CURRENT STOCK MARKET PE RATIO & THE SHILLER PE RATIO

Comparing the current stock market PE ratio and Shiller PE ratio to the historical averages

What is the S&P 500 PE Ratio

The S&P 500 PE ratio is a measure of the price-to-earnings ratio of the companies in the S&P 500 index. It is a valuation metric used by investors to assess the relative value of the S&P 500 index as a whole or individual stocks within the index.

The PE ratio is calculated by dividing the current market price per share of a company by its earnings per share (EPS) over the past 12 months. For the S&P 500 index, the PE ratio is calculated by taking the sum of the market capitalizations of all the companies in the index and dividing it by the sum of the earnings of those companies over the past 12 months.

For example, if the total market capitalization of the companies in the S&P 500 is $25 trillion, and the total earnings of those companies over the past 12 months is $1 trillion, the PE ratio of the S&P 500 would be 25 ($25 trillion divided by $1 trillion).

The PE ratio is a widely used measure of stock valuation, and a higher PE ratio generally indicates that investors are willing to pay more for each dollar of earnings. However, a high PE ratio can also suggest that a stock or an index is overvalued, while a low PE ratio may indicate that it is undervalued.

How to use the current S&P 500 PE ratio vs Historical S&P 500 PE ratio to assess current market valuation

Comparing the current S&P 500 PE ratio to its historical average can provide insight into whether the index is currently overvalued or undervalued relative to its past valuation levels.  

The current all-time historical average can be seen on the chart.

If the current PE ratio is significantly higher than the historical average, it may suggest that the index is overvalued and due for a correction. 

Conversely, if the current PE ratio is significantly lower than the historical average, it may suggest that the index is undervalued and could present a buying opportunity.

Problems using the regular PE ratio for valuation

The regular P/E uses the ratio of the S&P 500 index over the trailing 12-month earnings of S&P 500 companies.

During economic expansions, companies have high-profit margins and earnings. The P/E ratio then becomes artificially low due to higher earnings.

During recessions, profit margins are low and earnings are low. Then the regular P/E ratio becomes artificially higher and so you may miss good buying opportunities thinking the PE ratio is too high.

The solution is to use the Shiller PE ratio, detailed below

What is the Shiller PE ratio? (aka CAPE ratio)

The Shiller PE ratio, also known as the cyclically adjusted price-to-earnings (CAPE) ratio, is a measure of stock market valuation that adjusts for inflation and cyclical trends in earnings. The ratio was developed by Nobel laureate economist Robert Shiller and is based on the historic work of Benjamin Graham and David Dodd.

The Shiller PE ratio is calculated by dividing the current price of the S&P 500 index by the average of ten years of inflation-adjusted earnings per share (EPS) for the companies in the index. The result is a ratio that reflects the price investors are paying relative to the average earnings of the companies in the index over the past decade, adjusted for inflation.

For example, if the current price of the S&P 500 index is $4,000, and the average inflation-adjusted earnings per share over the past ten years is $100, the Shiller PE ratio would be 40 ($4,000 divided by $100).

How to use the current Shiller PE ratio vs Historical Shiller PE ratio to assess current market valuation

Comparing the current Shiller PE ratio to its historical average can provide insight into whether the stock market is currently overvalued or undervalued relative to its past valuation levels.

The current all-time Historical average can be seen on the chart.

If the current Shiller PE ratio is significantly higher than its historical average, it may suggest that the market is overvalued and due for a correction. Conversely, if the current Shiller PE ratio is significantly lower than its historical average, it may suggest that the market is undervalued and could present a buying opportunity.

Advantages of using the Shiller PE ratio over the regular PE ratio for valuation

The Shiller PE Ratio is often considered to be a better measure of stock market valuation than the regular PE ratio because it takes into account the impact of inflation and adjusts for cyclical trends in earnings.

Here are some reasons why the Shiller PE ratio may be considered better than the regular PE ratio:

Adjusts for Inflation: The Shiller PE ratio adjusts for inflation by using real earnings over the past decade. This means that it provides a more accurate measure of how much investors are paying for a company’s earnings power, rather than just nominal earnings that can be distorted by inflation.

Smooths Out Earnings Cycles: The regular PE ratio can be skewed by short-term fluctuations in earnings, which can make a company appear cheap or expensive based on a single year’s earnings. The Shiller PE ratio smooths out these short-term fluctuations by averaging earnings over a 10-year period, which provides a more stable and reliable measure of earnings power.

Provides Long-Term Perspective: The Shiller PE ratio provides a long-term perspective on market valuations, which can help investors avoid the pitfalls of short-term thinking. By looking at the average earnings over the past decade, investors can get a better sense of whether the market is overvalued or undervalued relative to historical norms.

Predictive Power: Studies have shown that the Shiller PE ratio has some predictive power for future stock market returns. While it is not a perfect predictor, it can help investors identify periods of potential overvaluation or undervaluation.