Shiller PE's and Modeling Stock Market Returns

By Joseph A. Tomlinson, FSA, CFP

January 19, 2010
One of the most popular assumptions use in in!estment
moelin" is that sto#$ pri#es follo% a ranom %al$. &o%e!er, a
"ro%in" 'oy of e!ien#e sho%s that this is a 'a assumption,
an that sto#$ pri#es "o throu"h perios of o!er(pri#in" an
uner(pri#in" that affe#t future returns. )any of the moels
use 'y finan#ial planners are 'ase on the ranom %al$
assumption. This naturally raises the *uestion of %hether %e
#an usefully 'uil in!estment moels 'ase on more realisti#
assumptions. +n this arti#le, + propose that %e #an 'uil 'etter
moels an pro!ie some initial su""estions on ho% to o so.
,ast fall + %rote t%o arti#les for Advisor Perspectives -see here an here.
is#ussin" the use of sto#$ mar$et !aluations to prei#t lon"(term sto#$ mar$et
performan#e. The parti#ular !aluation measure + use %as a pri#e/earnin"s ratio
that smoothes out #y#li#al earnin"s 'y in#luin" ten(year a!era"e earnin"s in the
enominator. + referre to this measure as the Shiller P0 'e#ause the main
proponent of its use has 'een Professor 1o'ert Shiller of 2ale 3ni!ersity %ho
hi"hli"hte it in his 'oo$, 4+rrational 05u'eran#e,4 an in earlier resear#h. This
measure is also $no%n as 46ormali7e Pri#e 0arnin"s 1atio,4 4P0 10,4 an
4Cy#li#ally A8uste P0 -or CAP0..4 All referen#es 'elo% to P0 ratios are to
Shiller P09s.
1e#ently + e5amine this measure more eeply %ith the "oal of 'uilin" a simple
sto#hasti# moel 'ase on the intera#tion of P09s an sto#$ mar$et rates of
return. A sto#hasti# moel of this type #oul 'e useful in impro!in" the )onte
Carlo pro8e#tions of in!estment returns, an ma$in" impro!ements to one of the
prin#ipal tools use 'y finan#ial planners.
)y %or$in" hypothesis is that P09s are in!ersely #orrelate %ith future returns,
'ut, on a year(to(year 'asis, any impa#t is mostly ro%ne out 'y ranom
influen#es. O!er time these P0 effe#ts a##umulate an si"nifi#antly affe#t
performan#e. So +9m assumin" that the sto#$ mar$et almost : 'ut not #ompletely
: follo%s a ranom %al$ an that lon"(term in!estors #an 'enefit 'y a8ustin"
portfolios 'ase on #urrent le!els of P09s.
+ 'e"an 'y e5aminin" histori# sto#$ mar$et performan#e ata "oin" 'a#$ to 192;
alon"sie Professor Shiller9s ata on histori# P09s. Tests of the relationship
'et%een 'e"innin"(of(year P09s an one(year returns prou#e the e5pe#te
< Copyri"ht 2010, A!isor Perspe#ti!es, +n#. All ri"hts reser!e.
ne"ati!e #orrelation %ith a #oeffi#ient of (.2= an an 1(s*uare measure of .0=>. A
rou"h translation is that the 'e"innin"(of(year P0 e5plains a'out =.>? of that
year9s sto#$ mar$et return. The !ariation of the yearly returns aroun the
re"ression line %as #onsiera'le : e*ui!alent to a stanar e!iation of 20?,
a'out the same as e5pe#te o!erall sto#$ mar$et !olatility. For moelin" one(
year sto#$ returns as a fun#tion of the 'e"innin"(of(year P0, + appro5imate the
relationship %ith the e*uation@
1eturn A -.2=.B-.9C.DP0 E 6-0, .20.
%here 6-0, .20. is a ranomly "enerate normally istri'ute !aria'le %ith 0
mean an a stanar e!iation of 20?. For e5ample, at a P0 of >Fthe lo%est
e5perien#e sin#e 192;Fthe e5pe#te return is 1;? plus or minus the ranom
term. At the all(time hi"h P0 of G2, e5perien#e 8ust 'efore the 'urstin" of the
ot(#om 'u''le, the e5pe#te return is H? plus the ranom term. Basi#ally, the
moel refle#ts the ata, %hi#h sho% that the 'e"innin" P0 e5erts an influen#e on
the e5pe#te return for the year, 'ut %ith #onsiera'le ranom noise.
Completin" the moel re*uires another e*uation to "enerate the en(of(year
P09s. As one mi"ht e5pe#t, ea#h annual #han"e in P0 is #losely relate to that
year9s rate of return. Base on this relationship an the histori# ata, + e!elope
the follo%in" e*uation to "enerate the enin" P09s@
P0-tE1. A P0-t.B-1E.90B1eturn-t.(.0;GE6-0,.0>..
These e*uations #an 'e #om'ine in an 05#el moel, an repeate simulations
#an 'e run usin" 05#elIs ranom num'er "enerator.
Ta'le 1 pro!ies a #omparison of a#tual !ersus test results. 0a#h of the tests
in!ol!e 10 runs of ;1(year -192; : 200;. !ersions of the moel, so the a!era"e
of all tests is 'ase on C0 simulations. O!erall, the moel prou#e a "oo fit
%ith the a#tual ata. The a!era"e P0 from the moel #ame in sli"htly hi"her than
the a#tual a!era"e P0, 'ut it9s un#lear %hether %e nee to fine(tune the moel or
a##ept that the a#tual num'ers %ill #ontain some statisti#al !ariation. -The a#tual
histori# num'ers are really 8ust a sample, an may or may not represent a 'est
estimate of num'ers "oin" for%ar..
Jhat is perhaps most interestin" in the #omparison is that the #orrelations an
1(s*uares are hi"her for the a#tual than for the a!era"e of the tests. )y "uess is
that there are li$ely #loser ties 'et%een P09s an su'se*uent performan#e than
are #apture 'y my simple moel, 'ut + ha!e no %ay of pro!in" this. +n "eneral, it
loo$s li$e this moel pro!ies a "oo start to%ar 'uilin" a %or$a'le simulation
moel to sho% the effe#t of P09s on performan#e.
< Copyri"ht 2010, A!isor Perspe#ti!es, +n#. All ri"hts reser!e.
Ta'le 2 pro!ies a #omparison of test results %ith the asset allo#ation results +
e!elope in the first arti#le referen#e a'o!e. Base on a small sample of 8ust
10 #ases, the results for the test #ases are similar to the a#tuals, althou"h the
a#tuals sho% a 'i""er impa#t from in#orporatin" P09s in the asset allo#ation. This
result is #onsistent %ith the lo%er #orrelations for the test results sho%n in Ta'le
1.
The 'eha!ioral influen#e on sto#$ pri#es has 'een es#ri'e in the popular press
as an e5#ess of "ree %hen sto#$ pri#es are hi"h, an an e5#ess of fear %hen
pri#es are lo%. The result is sto#$ pri#e mo!ements that o not follo% a ranom
%al$. This moel also re8e#ts the ranom %al$ assumption, 'ut it is 'ase on a
ifferent #hara#teri7ation of in!estor 'eha!ior : some fear -'ut not enou"h. %hen
pri#es are hi"h, an some "ree -'ut not enou"h. %hen pri#es are lo%. To the
e5tent %e #an impro!e our unerstanin" of in!estor 'eha!ior an 'uil
simulation moels that refle#t its effe#t on in!estment returns, %e #an pro!ie
more useful tools for finan#ial planners an their #lients.
< Copyri"ht 2010, A!isor Perspe#ti!es, +n#. All ri"hts reser!e.
Table 1 - Shiller PE's and Returns--Actual versus Test Results

Averages PE Return Std Dev
of Return
Loest
PE
!ighest
PE
"orrelation
PE and 1#-$r
Returns
R-
S%uare
Test &1 19.G= 10.>G? 20.G>? >.9 GH.2 (0.C> 0.HG
Test &' 1=.GG 11.21? 21.09? =.1 HH.; (0.CH 0.H2
Test &( 1;.1C 11.0>? 20.;G? >.1 G0.2 (0.=G 0.G2
Test &) 1=.H2 11.G1? 19.;>? =.; HH.; (0.=1 0.H9
Test &* 21.0; 11.G2? 20.G1? >.2 GG.9 (0.=1 0.H;
Average
All Tests
1;.29 11.1>? 20.CG? >.0 H9.2 (0.C9 0.H>
Actual
1+',-'##,
1>.H> 11.09? 20.H9? >.G G2.C (0.=9 0.G>
Table ' - Asset Allocation Results--Test versus Actual

*#-*# .ond-Stock
.u/ and !old
*#-*# Annual
Rebalance
PE-.ased
Allocation .u/
and !old
PE-.ased
Allocation
Annual
Rebalance
Average of 1#
test "ases
>.;G? >.99? ;.G0? ;.>1?
Difference vs0
*#-*# .u/ and
!old
0.00? 0.1C? 0.C=? 0.;>?
.ased on Actual
1+',-'##,
;.H0? ;.G1? 9.GC? 9.=C?
Difference vs0
*#-*# .u/ and
!old
0.00? 0.11? 1.1C? 1.HC?
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< Copyri"ht 2010, A!isor Perspe#ti!es, +n#. All ri"hts reser!e.