In The Shiller Ten-Year P/E Ratio I wrote, “In his book “Irrational Exuberance,” Shiller shows that P/E 10 is correlated to the subsequent 20-year annualized return after inflation. A low P/E 10 bodes well for the next 20 years of investing, whereas a higher P/E 10 suggests a lower expected return.”
Charlie Tian’s GuruFocus.com has a nice article on Shiller P/E – A Better Measurement of Market Valuation in which they write:
If we assume that over the long term, the Shiller P/E of the market will reverse to its historical mean of $mean, the future market return will come from three parts:
- Contraction or expansion of the Schiller P/E to the historical mean
- Business growth
The investment return is thus equal to:
Investment Return (%) = Dividend Yield (%) + Business Growth(%) + (Mean_Shiller_PE/Current_Shiller_PE)(1/T)-1
From this we will estimate that at the Shiller P/E’s current level, the future market return will be around 2.4% a year. This is the historical implied return, actual return and long term interest. Interest rate does have an impact on the market returns. Click on the legend of the chart below to show/hide chart series.
In reality, it will never be the case that Shiller P/E will reverse exactly to the mean after 8 years. Table below give us a better idea on the range of the future returns will be if the market are within 50% to 150% of the mean.
Scenario Shiller P/E after 8 Years Annual Return from Today (%) Really Lucky Mean x 150% 7.4% Lucky Mean x 125% 5.1% Reverse to the Mean Mean x 100% 2.4% Unlucky Mean x 75% -1.1% Really Unlucky Mean x 50% -5.7%
And if you would like to learn how to apply these numbers:
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