Shiller’s Nobel Win and the markets

Shiller’s method is broadly used in the investment industry and the recent Nobel prize shows his influence on the investment science in the last decade. Many traders and investors prefer what is called the "Shiller P/E," named after the Yale University economics professor. Instead of comparing price and earnings data for the last 12 months, or forecasting it for the next 12, the Shiller P/E relies on the previous 10 years of inflation-adjusted data. "From one year to the next, earnings can vary widely," says John Mauldin, chairman of Dallas-based research firm Mauldin Economics. "The reason you use the Shiller ratio is to smooth out those earnings gaps, and get better historical context."

Now Shiller seems he is our contemporary guru. He forecasted the two biggest bubbles in 2001 the tech one and in 2007 the real estate and credit crunch one. The question is how he could do that? He has an own system. He states the markets are inefficient.  The Shiller P/E ratio is based on average inflation-adjusted earnings from the previous ten years. Major bottoms for the P/E ratio coincided with major lows in 1920, 1932, 1982, and 2009. Breaks above the longer-term downtrend line in the Shiller P/E have preceded market rallies and higher valuations. These downtrend line breaks occurred in 1922, 1945, 1951, 1983, and 2011.

So what is it telling us now? The Standard & Poor's 500's trailing P/E now stands at 23.90, above its long-term historic average of roughly 15.5, but not egregiously so. So the good news is that secular trading ranges lead to better valuations that limit late stage secular trading range pullbacks. So don’t panic – we don’t expect anything like the 2000 or 2008/2009 period. Note that during periods of market consolidation valuation levels as measured by price/earnings multiple reaches extreme cheapness – 5.3x December 1917, 5.8x June 1949, 6.8x April 1980 and so far 13.5x in September 2011. An important point is that the market bottoms before the price-earnings multiple does.

And finally I recommend his two books to read:

-         Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, George A. Akerlof and Robert J. Shiller, 2009.

-          Shiller, Robert J. (2000). Irrational Exuberance. Princeton University Press

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