Valuations, Inflation and Real Returns

by Charles Rotblut, CFA and Robert Shiller

Listen to Robert Shiller's presentation at the AAII Investor Conference!

Robert Shiller is the Sterling Professor of Economics at Yale University. He developed a cyclically adjusted price-earnings ratio, called the CAPE ratio. We spoke recently about his research on stock asset valuations an


About the author

Charles Rotblut is a vice president at AAII and editor of the AAII Journal. Follow him on Twitter at
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Robert Shiller is a Nobel laureate and the Sterling Professor of Economics at Yale University.
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—Charles Rotblut

Charles Rotblut (CR): Can you explain what your CAPE ratio is and what it measures?

Robert Shiller (RS): The basic idea is that you need some measure of value relative to fundamentals. You can’t just look at price per share, which doesn’t tell you how something is over- or undervalued, but price relative to something. It seems to me that earnings is the natural candidate to compare price with. But the problem with earnings as it is used is that people tend to use lagging one-year earnings or projected earnings for the next year. One year is just too short of a time period because earnings are volatile and they jump around. In particular, the business cycle affects earnings. When we are in a recession, earnings tend to be low, for instance. So, I don’t think we should overreact to short-term fluctuations in earnings.

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CAPE is called cyclically adjusted price-earnings ratio, and it is cyclically adjusted in the sense that we average the earnings over a longer interval of time. I have been using 10 years, which seems like a very long time for most finance people. People tend to think that something that happened 10 years ago is just so long ago that it is irrelevant. But, the conservative strategy argues that, no, it is not irrelevant and that companies last a long time. In order to really get a sense of their value, you have to look at a 10-year history and that is what I have been doing. I work with a former student, who is now a Harvard professor, John Campbell. We found that real price divided by 10-year average of earnings does actually help predict the stock market.

The stock market is somewhat predictable, using data all the way back to 1881. It has held up for a long period of time. The CAPE ratio does not predict what is going to happen next year very well. It is for long-term investors. It predicts what will happen over the next five or 10 years. In other words, when prices are high relative to 10-year average earnings, then that suggests that prices will come down, but you don’t know exactly when. You might have to wait five years or 10 years for them to come down. For patient, long-term investors, I think it makes sense to follow CAPE as an indicator of value.

CR: What is the CAPE right now?

RS: It reached 23.3 on May 7, the day that the Dow first broke 15,000, and that is high. [Figure 1 shows the CAPE over time from Shiller’s website]

CR: What should a long-term investor looking at the number do? Should they hold off on stocks or lighten up on their allocations? What would you suggest?

RS: You have to compare the alternatives. The problems now are that the main alternatives are not very good either. Long-term bond yields are near record lows, short-term interest rates are just about zero and the Treasury Inflation-Protected Securities (TIPS) are actually paying a negative yield out 10 or 15 years, so the alternatives are not very good. Taking that into account, the stock market doesn’t look so bad. I’m thinking that people should have something in stocks. You have to put your money somewhere, so although the CAPE ratio is high, it is not super high. In the year 2000, it was twice as high as it is now; I thought that was a bad signal, and I was right about that. We aren’t getting such a bad signal now from CAPE, so I think it is still important to put something in the market.

CR: If we were in a more normal situation for interest rates and bonds looked more attractive for investors, should investors put less in stocks or pull out of stocks until the ratio goes down? Using the year 2000 as an example, what should an investor have done at that point?

RS: In 2000, that’s when my first edition of “Irrational Exuberance” (Princeton University Press) came out, I expressed strong worries about the stock market. So the smart thing to do would have been to pull out completely or almost completely in 2000. In fact, more aggressive investors may have shorted the market. Shorting the market is a more aggressive policy that most people won’t do.

The question today is whether you want to short the bond market. And in a sense, I think you do want to short it. One thing is to buy a house and get a mortgage. Mortgage rates are so low now, so borrowing to buy a house is like shorting the bond market.

We live in a very unusual financial world right now. I find it so strange that the TIPS (Treasury Inflation-Protected Securities) yield is negative because that means that long term, 10 years, you can’t make a riskless return at all in real (inflation-adjusted) terms. Nothing. Less than nothing. If you invest your money, and you want it to be riskless, you are guaranteed that you will lose money. Guaranteed. But then it becomes a problem of preservation. There isn’t any safe way to store value and make money. If it is safe, it is losing money. If it is safe in real terms, it is losing money. And that’s just the world we live in now.

Source: Data as of May 5, 2013.
Charles Rotblut, CFA is a vice president at AAII and editor of the AAII Journal. Follow him on Twitter at
Robert Shiller is a Nobel laureate and the Sterling Professor of Economics at Yale University.


fang from ms posted about 1 year ago:

after all the vacillation, the last paragraph is best advice!

Joe E from Florida posted about 1 year ago:

I read both editions of Irrational Exuberance as soon as they were published. The first edition, focused upon the stock market, allowed me to avoid the first internet boom, and to make outsized returns taking the opposite side of the trade from the trend followers. The second edition, which added the housing market analysis, I pretty much ignored. This cost me a pretty penny as I found myself with an extra Florida beachfront condo at a very inopportune time.
One piece of wisdom contained in the interview is that the larger companies are followed by Very Smart People with world-class intelligence gathering systems. Smaller companies are not nearly as well followed. Value Line has a pretty good product covering these companies for those with the time to invest as well as the money.

Vaidy Bala from Canada posted about 1 year ago:

Investment is done to profit not for fun, for most people anyway. Do Index or hand over to adviser. You cannot beat intelligent people. This seems to be the summary. So, what is new in Irrational Exuberance that we did not know?

Dick H from VA posted about 1 year ago:

Prof. Shiller's last paragraph points me to the AAII Shadow Portfolio.

Jim Morlock from NJ posted about 1 year ago:

This an excellent article. I would like to see AAII keep these charts up to date on a monthly basis.

Ed from Maine posted about 1 year ago:

By simply studying and thinking about the CAPE graphic and the Real Estate graphic on Schiller's website, one can draw meaningful inferences. A good shortcut.

Ed from Maine

Shyam from California posted about 1 year ago:

Excellent insight about the financial market.

Al from Jamaica from Jamaica posted about 1 year ago:

Good article, tentative and suggestive about his own advice/conclusions, bottom line on equities might be "recommend diversified investment in index funds, with a bit of 'shadow stock' play?"

Roger Mckinney from OK posted about 1 year ago:

Shiller's nemesis, Fama, has modified the CAPM to show that small cap, value and momentum stocks will outperform the broader averages. There are good economic reasons for that.

I think the AAII screens provide the best advice for investors. Professionals are biased and research has shown that simple objective tools, such as linear regression, can beat pros nine times out of ten. Pick a screen that fits your philosophy and stick with it. You will beat the market easily.

But one of the most important things to know is when a recession is coming and avoid the market crash that comes with it. The Austrian business cycle theory can help.

Peter Yogman from UT posted about 1 year ago:

Roger you are right. Any AAII stock screen pretty much trashes the efficient market theory and that goes beyond just bubbles and crashes that Shiller references as the theory's weakness. Get an advisor, buy broad ETF's, and end up with less than you started with - guaranteed. In addition to business cycle theory check out demographic trends (eg. HSDent) Really long term but informative.

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