Further Reasons Why I Use the Shiller PE10

Regular readers will know that to try and squeeze some more performance out of a retirement investing strategy that is heavily focused on asset allocation I use a cyclically adjusted Price / Average 10 Year Earnings (PE10) ratio for the S&P 500 to value the US stock market. The method used is that developed by Yale Professor Robert Shiller. My latest update is that for January ’10.

The first chart today shows the chart that I show each month which reinforces why I use this method. The R^2 value is low at 0.0566 and the correlation is also low at -0.15. That said however these values, along with a look at the trend line, suggests that some advantage may be able to be taken of the relationship. I must point out here how the x and y axes are calculated for this chart.

The x axis should not be an issue for any regular reader. It is simply the monthly PE10 ratio which is the real (ie inflation adjusted back to 1871) price of the S&P 500 divided by the real monthly average of the previous 10 years earnings. The y axis is the real price in 13 months time minus the real price in 1 months time plus the real dividend all divided by the real price in 1 months time. Hope that makes sense... It is also important to note that I then calculate these values every month to form the scatter chart that I show.

I have been thinking about the fact that I am only analysing the historical return on investment from the S&P 500 that can be expected for a period of 1 year. I am certainly not a 1 year investor and so I wondered what these charts would look like for 5 or even 10 year periods.
To do this easily I am going to switch from monthly data points to one data point for each year which I have chosen to be January for no other reason than it is the first month of the year. This is because before I can run the real return calculations I first have to calculate a total return for the S&P 500 going back to 1871 and this is easiest done with yearly data.

Now to the interesting bit. Firstly, as a comparison to the monthly chart above my second chart shows the 1 year real total return versus the PE10. Charts three and four then show the 5 and 10 year real total return versus the PE10. Examining the R^2 and correlations shows:
1 year, R^2 0.0462, correlation -0.21
5 year, R^2 0.1554, correlation -0.39
10 year, R^2 0.2725, correlation -0.52

This for me is really interesting. It suggests that the longer the period of time you hold the stocks or equities the more the Shiller PE10 becomes a useful measure for predicting future expected real returns. This reinforces why I am using the PE10 ratio as part of my retirement investing strategy.

As always some assumptions:
- Q1 ’09 & Q2 ’10 earnings are estimates from Standard & Poors.
- Inflation data from the Bureau of Labor Statistics. December ‘09 & January ‘10 inflation is extrapolated.
- January ‘10 dividend is estimated as December ‘09 dividend.
- Prices are month averages except January ‘10 which is the 11 January ’10 S&P 500 stock market close.
- Historic data provided from Professor Shiller website.