The Shiller P/E Ratio Deconstructed

Philosophical Economics blog goes into detail to explain why the Shiller P/E ratio (a.k.a. the CAPE ratio) has been historically high for a long time. He also points out that more traditional P/E ratios also have been historically high. After explaining why several factors cause the rise in the CAPE, the blog lists several possible investment scenarios and opines that a moderately bearish scenario is most likely.

As for me, I tend to lean towards option #2: a moderately bearish outcome.  I’m expecting weak long-term returns, with some profit margin contraction as labor supply tightens, and some multiple contraction as Fed policy gets more normal–but not a return to the historical averages.  Importantly, I don’t foresee a realization of the moderately bearish outcome any time soon.  It’s a ways away.

I expect the market to eventually get slammed, and pay back its valuation excesses, as happens in every business cycle.  If this occurs, it will occur in the next recession, which is when valuation excesses generally get paid back–not during expansionary periods, but during contractions.  The next recession is at least a few years away, maybe longer, and therefore it’s too early to get bearish.  Before sizeable recession becomes a significant risk, the current expansion will need to progress further, so that more real economic imbalances are built up (more misallocations in the deployment of the economy’s real labor and capital resources), excesses that provoke rising inflation, and that get pressured by the monetary policy tightening that occurs in response to it.  In the meantime, I expect the market to continue its frustrating and painful grind higher, albeit at a slower pace, offering only small pullbacks in response to temporary scares.  Those who are holding out for something “bigger” are unlikely to be rewarded any time soon.