Famous Shiller P/E valuation gauge flashes sub-par decade of return for US equities

Famous valuation gauge flashes sub-par decade for US equities

US stocks have now crossed a rarely tested valuation level which could mean a decade of poor returns, the Wall Street Journal has reported citing the famous Shiller P/E valuation framework.

For only the second time ever, the cyclically adjusted price-to-earnings ratio, made popular by Nobel laureate Robert Shiller and originally proposed by Benjamin Graham, has moved above 40, a level last seen during the peak of 1999 tech bubble.

Historically, data shows that peaks at these levels have been followed by negative real 10-year returns for US equities, including 1929, 1966 and 2000.

While US bulls may argue that this time might be different as the US index composition is far more software / asset-light / AI led, but margins appear structurally richer. Microsoft has operating margins 5x that of Exxon Mobil and almost 10x that of Walmart. The WSJ report added that this argument weakens when one benchmarks through the long-cycle valuation.

Even adjusting for the average starting from 1990 not 1881, the modern long-run Shiller P/E averages around 27, thus making current over 40 level as extreme.

The argument that “earnings will just structurally rise forever” is also challenged by fiscal / demographic realities. US corporate tax rate is already low, labour share is depressed, US deficits are large, and ageing demographics will likely raise cost pressures.

The WSJ report has projected that AI could expand productivity but it would need to be so transformational and sustained that it merely drags valuations back toward averages, not even justify these levels.

Research Affiliates model, also cited by the WSJ, has forecast a negative 1.1 percent real return over the next decade for large US growth stocks (including Magnificent Seven) based on cyclically adjusted P/E inputs. Large-value stocks could still deliver around +1.6 percent real return, while US smallcaps are much better placed at +4.8 percent real returns, while Europe and Emerging Markets show even better forward-looking real returns around 5-5.4 percent.

Indian mutual fund’s passive global allocation may get impacted if these valuation models play out.

The Shiller P/E isn’t a short-term trading timing tool, and can stay elevated for years, but historically it has been extremely reliable in warning investors before major periods of long-duration return compression.

With Shiller P/E valuation at over 40 now, the WSJ reported that said that something eventually must give, more likely the price than earnings.