I’ve been working on an article all week, but I didn’t get it ready in time to publish. It could easily be a 20+ page research paper or a longer book. Instead of that, you’ll have to suffer through an article that’s actually relevant to what this website is about.
Over the last 20 years, I’ve written about Shiller P/E quite a few times. It’s a great way to KNOW which way the market will go. Let me take a step back.
What is the Shiller P/E
The Shiller P/E ratio—also known as the CAPE ratio (Cyclically Adjusted Price-to-Earnings)—is a valuation measure for the stock market created by Nobel Prize–winning economist Robert Shiller. The Shiller P/E uses the current stock market price and the average real earnings from the previous 10 years, adjusted for inflation. If you invest when the Shiller P/E is low, you are paying a low price for high earnings. If you invest when the Shiller P/E is high, you are paying a high price for low earnings. If you’ve ever heard of “buy low, sell high,” using the Shiller P/E is a great guide.
[Note: This is a VERY simplified explanation. I wouldn’t buy and sell all my stock holdings based on this. Stick with me until the end of the article, and I’ll explain what I do.]
Here’s what a chart of the Shiller P/E looks like over the last 100 years.
Take a look at the big spikes and you’ll see bubbles of the past. The stock market bubbles and crashes of 1929 and 1999 seem the most obvious. You can also see the crash of the Great Recession of 2009. More recently, the Shiller P/E hit a high of 39.43 on in early November 2021. That’s when I asked the question Is Now the Time to Start Selling Stocks? The S&P 500 peaked at around 4700 in November and December and dropped to around 3600 by next October when the Shiller P/E dropped to around 28.
That’s enough of the history lesson. Hopefully, by now, your eyes will have drifted to the right to see that the Shiller P/E is now over 40. That’s the highest it’s been since it reached 44 during the dot-com craze and subsequent bomb.
That Shiller P/E is currently the second highest of all time, behind the one a little more than 25 years ago. However, I said it was the biggest market bubble in 50 years. Something doesn’t add there, does it?
Let me introduce you to…
The Buffett Indicator
The Buffett Indicator is another measure of whether the stock market as a whole looks overvalued, fairly valued, or undervalued. It was by the best investor of all time, Warren Buffett. Specifically, the Buffett Indicator is the ratio of the total value of the stock market to the size of the economy. The total value of the stock market is measured by the Wilshire 5000, and the size of the economy is measured by the Gross Domestic Product (GDP).
Buffett has claimed that this number is the “single best measure” of the value of the stock market. When this number is 100%, the market is fairly valued. When it is lower, the market is cheaper. When it is higher, the market is more expensive. This is just like the Shiller P/E.
Here’s what the Buffett Indicator looks like since 1970 (as far back as I could find a chart):
The Buffett Indicator in the dot-com bubble of 1999 “only” reached 1.35. Over the last five years, it has lived over 1.50 and is currently at 2.19. That’s record territory – far beyond the dot com Indicator.
Managing The Biggest Stock Market Bubble in 50 Years
Let’s recap:
- The Shiller PE tells you if investors are overpaying for profits.
- The Buffett Indicator tells you if the market as a whole is oversized compared to the economy.
Taken together, the market is the highest ever compared to the profits and the size of the US economy.
So does that mean you should sell all your stocks? I’m not a financial advisor, so I can’t tell you what to do. Making extreme moves of buying and selling while trying to time the stock market has historically turned out very badly.
Remember when I wrote the article in May of 2021, saying that the Shiller P/E was high? It went higher for another several months. Many times, a high stock market can continue to go higher. If you look at the two above charts again, you’ll notice that in recent years, the “new normal” has been high numbers in general. With the benefit of hindsight, we know that being invested in the stock market has been ideal.
Need another reason to stay invested? Take a look at the S&P 500 from 1996 until today:
When you look at that chart, it doesn’t seem like a bad idea to have bought in the previous biggest market bubble of 1999. Even if you bought at the worst time, you would have about five times more money today. That’s why you may hear people say that the time you have your money in the market is much more important than timing the market.
I’m wired a little differently than most people, and I like following these things. Because of that, I allow myself to make minor moves with my asset allocation. For example, when the drop happened in 2022, I bought a lot of tech stocks (specifically the Nasdaq index, QQQ). No one wanted Meta because they were throwing away tons of money in virtual worlds. Fast forward a few years, and you could have made an 800% return. Many people wondered where the innovation in tech was going to come from.
A couple of years ago, I invented the Lazy Man Rule of 20. That means that I subtract 20 from the Shiller P/E to get the amount of bonds I should have in my portfolio. So when the Shiller P/E gets to 38, I should have 18% bonds and 82% stocks. If the Shiller P/E is 22, I’d have only 2% bonds and 98% stocks. This way, I’m always invested, but when the inevitable crash of the Shiller P/E happens, it’s likely to impact bonds less. Recently, I’ve been adding some treasury bills with the SPDR Bloomberg 1-3 Month T-Bill ETF (ticker: BIL). That’s because I’ve read that bonds are not particularly safe in this market either.
In addition to the stock/bond allocation, I also move my stock holdings to a less volatile index. Instead of holding tech stocks that have soared for a long time, I’m holding more dividend and consumer staple stocks. It’s still the stock market, but those who survive a crash do a lot better. It’s important to note that I only make changes to asset allocation in my retirement accounts so that I don’t trigger tax events.
There’s a chance that I’m missing out on a bigger run of tech stocks going forward as artificial intelligence takes over the earth. I don’t have FOMO at all, though. I’ll still make plenty of money if that happens. If it doesn’t, then the Shiller P/E has guided me in the right direction as it has time and time again.
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