Is the market overpriced according to Shiller PE ratio?

Warren Buffett famously said, "The first rule of investing is never to lose money."

One surefire way to risk losing money is by buying something overpriced.

But how do you know if an asset is overvalued?

Shiller PE ratio is a powerful metric that helps investors assess whether the market is expensive compared to its historical average.

Let’s explore what the Shiller PE ratio tells us about today’s market, and why it matters for your investment strategy.

What Is the Shiller PE Ratio?

The Shiller Price-to-Earnings (PE) ratio, also known as the cyclically adjusted price-to-earnings ratio (CAPE), is a valuation measure developed by Nobel Prize-winning economist Robert Shiller. It smooths out short-term market volatility and offers a long-term perspective on stock valuations by using inflation-adjusted earnings over the last 10 years instead of focusing on just the most recent year’s earnings.

How Is It Calculated?

To calculate the Shiller PE ratio:

Take the S&P 500’s current price.
Divide that price by the average inflation-adjusted earnings over the past 10 years.

This approach provides a broader view of market valuation, allowing investors to see past short-term economic cycles and better gauge whether the market is over- or undervalued.

Why Is It Significant?

The Shiller PE ratio is particularly useful for long-term investors.

Historically, high Shiller PE ratios have correlated with lower future market returns, while low ratios have suggested better buying opportunities.

Investors often use this metric to inform their decisions, especially when considering whether the market is overpriced or underpriced.

Source: https://www.multpl.com/shiller-pe

Historical Insights: Expensive vs. Cheap

The Shiller PE ratio has been a reliable indicator of market extremes:

Expensive Market: During the dot-com bubble in 2000, the Shiller PE ratio soared to over 44. This unprecedented valuation signaled a dangerously overheated market, which eventually led to a significant crash.
Cheap Market: After the 2008 financial crisis, the ratio dropped below 15, indicating a period of undervaluation. Investors who took advantage of these lower prices saw substantial gains in the subsequent market recovery.

Where Are We Today?

As of August 24, 2024, the Shiller PE ratio stands at 36, a level that indicates significant overvaluation relative to its historical average of 17.

This elevated ratio is concerning for long-term investors, as it has often been followed by periods of lower market returns or corrections.

While today's high valuation does not guarantee an imminent crash, it suggests that investors should be cautious, particularly given the potential for economic headwinds, rising interest rates, and geopolitical uncertainties.

Historically, when the Shiller PE ratio has exceeded 30, markets have been followed by periods of slower growth or even downturns, such as in 2000 before the dot-com bubble burst.

That said, it’s important to remember that modern-day stock valuations—particularly in technology—are driven by different factors than in past decades.

Conclusion

The Shiller PE ratio offers a critical long-term perspective on market valuations.

At 36, the ratio signals a market that is quite expensive, raising the possibility of muted returns in the future.

While not a perfect market-timing tool, it provides valuable context for investors trying to balance risk and reward in their portfolios.

As we stand today, this elevated ratio is a reminder to exercise caution, as history has often shown that periods of high valuations are followed by corrections or slower growth.

Stay inspired!