King of the Mountain: The Shiller P/E and Macroeconomic Conditions

  • Robert D. Arnott, Denis B. Chaves, and Tzee-man Chow
  • Journal of Portfolio Management
  • A version of this paper can be found here

    • What are the research questions?

  • Is there a relationship between real yields and short-term market valuation?
  • Is there a relationship between inflation rates and short-term market valuation?
  • Does the predictive power of the Shiller P/Eimprove by using yields and inflation?

    • What are the Academic Insights?

  • YES. The authors describe a “mountain-shaped” relationship between stock market valuations and inflation rates and real yields. When levels of inflation and real yields are moderate, then the Market P/E rises above 16.7 (the unconditional historical average). When inflation or the real yield reside at extreme levels, the P/E is noticeably lower.  For the U.S., the Market P/E is generally at it’s highest when real yields are approximately 3% to 4%. When real yields are below 1% or above 6%, the P/E drops from 19.6 to 10.7. Outside this narrow interval, median P/Es fall rather quickly from a peak of 19.6 to 10.7 when real yields are below -1% and to 10.5 when real yields are above 6%.
  • YES. A similar pattern exists for inflation as does for real yields, relative to market valuation.  The median market P/E of 20.3 occurs when inflation is between 2% and 3%. However, as inflation increases the P/E declines faster than that observed for real yields. On the other side, the authors do not observe a steep decline in the P/E when the inflation rate also declines. Perhaps an equity investment is not as effective as a hedge against inflation as conventional wisdom suggests.
  • YES. Using a regression model with a defined Gaussian function conditional on current levels of inflation and real yields provides superior forecasts for forecast horizons of 3 years or less. At longer horizons, the conditional model produces inferior results for periods of 3 to 5 years or longer. At that span, the basic Shiller P/E model maintains its impressive well-documented performance.
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