Despite the recent Nobel Prize given to its originator, the Shiller cyclically-adjusted P/E (or “CAPE”) ratio continues to be controversial, driven in no small part by its current “reading” that markets are overvalued, yet they continue to climb higher and higher… a formula that has played out in the recent past as well, in both the mid-2000s and especially the late 1990s. Yet the poor recent predictive performance of Shiller CAPE shouldn’t entirely be a surprise; it has never had a particularly high correlation to year-over-year market returns.
Nonetheless, the reality is that while Shiller CAPE has little predictive value in the short term, its correlation to market returns is far stronger over longer time periods; Shiller CAPE shows its strongest correlation to nominal returns over an 8-year time horizon, and is actually most predictive of real returns over an *18* year time horizon… supporting Benjamin Graham’s old adage that the markets may be a voting machine in the short run, but they are ultimately a weighing machine in the long run as valuation eventually takes hold. On the other hand, over very long time horizons (e.g., 30 years) Shiller CAPE once again begins to lose its value as other longer-term structural market factors take hold.
The fact that Shiller CAPE is a strong predictor of market performance in the long run (but not the “ultra” long run, nor the short run) suggests that the valuation measure does have use, but only if applied in the correct contexts. For instance, while all this suggests that Shiller CAPE may be a poor market-timing investment indicator, clients who are retiring and exposed to “sequence-of-returns” risk over the first half of their retirement may benefit greatly by adjusting their initial spending levels in light of market valuation at the start of retirement. Similarly, those considering the benefits of delaying Social Security – or choosing to annuitize or claim pension payments over an equivalent lump sum – would do well to evaluate their decision in light of whether there is a market-valuation-based headwind or tailwind underway. Thus, even if Shiller CAPE is a poor market-timing indicator, that doesn’t mean it’s useless at all when it comes to retirement planning!