The Shiller P/E Enters Rarefied Air

January 6, 2015

by Keith Goddard, CFA

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The domestic stock market cannot deliver a sustainable double-digit return without entering a speculative bubble, based on historical data reflecting correlations between the level of the Shiller P/E and subsequent outcomes in the stock market over the past 134 years. Conditions are ripe for a speculative bubble in the domestic stock market in 2015, and investors should reduce risk in their portfolios in stages during the coming year.

Investors should expect below-average returns from the domestic stock market over the next five to 10 years. Indeed, to expect anything more than mid-single digits requires an assumption that stocks will enter a speculative bubble. The reason is valuation. From today’s valuation level the only way to sustain significant upside is to assume a future valuation multiple that would put the stock market into bubble territory.

The S&P 500 Index was recently trading at a cyclically adjusted price-to-earnings ratio, or “CAPE,”¹ of 27.3, meaning the stock market is priced at more than 27 times the 10-year average earnings of the underlying companies in the index. This is highly unusual. Out of 1,608 monthly observations between January 1881 and December 2014, the CAPE for the U.S. stock market has measured 27 or higher just 88 times. That is a frequency of only 5.5% throughout this 134-year period.