What the Shiller PE says about global equity markets

Update 2013
Joachim Klement
Chief Investment Officer
Wellershoff & Partners Ltd
E-mail: joachim.klement@wellershoff.ch

Abstract
We update our analysis of expected returns for equity markets around the world. Our
projected returns based on the current Shiller-PE of 38 developed and emerging equity
markets around the world indicates that expected real returns are still positive for the coming
5 to 10 years. In particular, European stock markets remain the most attractively valued stock
markets globally, while the US stock market is amongst the most overvalued markets. We
find that expected real returns for US stocks over the coming 5 to 10 years should be in the
order of 2% to 2.5% per annum, while European equity markets promise real returns in the
high single digits. Rising interest rates in the future might diminish these expected returns
further.
JEL classification: G12
Keywords: Shiller PE, cyclically adjusted PE, equity market returns

1
Electronic copy available at: http://ssrn.com/abstract=2336905

Last year we applied the trusted methodology of Ben Graham and David Dodd of cyclically
adjusting the price-to-earnings ratio to a wide range of countries around the world. The
cyclically adjusted PE-ratio (CAPE) that was popularized again by Robert Shiller and hence
is known also as Shiller-PE still is one of the most reliable indicators for long-term equity
market returns. In our original report we showed that while the US equity market was
strongly overvalued and promised only very low real returns going forward, European equity
markets looked much more promising (Klement [2012a, 2012b]).
A lot has happened since then. The Eurozone debt crisis seems to have all but disappeared
and European equity markets experienced a strong recovery since summer 2012. But even the
US stock market with its expensive valuations managed to rise by 27% since July last year.
This shows again that expensive stock markets can get even more expensive in the short run
and that a long-term valuation indicator like the Shiller-PE does not have any predictive
power for shorter time frames. Long-term investors need discipline and patience especially
when seemingly overvalued assets continue to post strong returns.
So with all these changes over the last year, we think it is time to update our analysis. In this
report we want to focus on the developments of the last year and show the Shiller-PE for 38
different markets around the world together with the expected real returns for the future. We
have slightly expanded our sample of countries and included Italy (Shiller-PE available from
January 1991), Spain (Shiller-PE available from January 1997) and Russia (Shiller-PE
available from January 2006). We have got responses to our original study from all over the
world asking for an update and an expansion of the covered countries so here it is. Enjoy our
outlook for equity markets
Developments over the last year
The US equity market was one of the best markets globally driven to a large extent by the
expansive monetary policy of the Fed. How else can one explain a stock market rising by
more than a quarter while US growth remained at a modest pace of below 2% and real
interest rates in negative territory? In our previous report we have estimated a
macroeconomically derived Shiller-PE that is driven by real growth, real per capita growth,
real interest rates and inflation. This macroeconomically derived Shiller-PE can be used as a
fair Shiller-PE given the current economic environment. Deviations from this fair ShillerPE reflect in our view overly optimistic or pessimistic expectations by investors as well as
other drivers or stock markets that do not directly influence the real economy. If we compare
this fair Shiller-PE with the actual Shiller-PE since the end of the financial crisis we see that
given the anemic growth of the United States economy valuations should have declined over
2
Electronic copy available at: http://ssrn.com/abstract=2336905

the last five years and stock market returns should have been low or even negative.
Shouldve, wouldve, couldve. What happened instead was that prices rose so much that the
Shiller-PE in the United States went from rather fair levels at the end of the financial crisis to
levels that are currently around 68% above the fair Shiller-PE. Long-term valuations in the
United Stock market are today amongst most expensive valuations ever recorded.
Exhibit 1: Fair Shiller-PE derived from macroeconomic variables and current Shiller-PE for
the US stock market
25
Fair ShillerPE
Current ShillerPE

ShillerPE

20

15

10
01/2008

01/2010

01/2012

01/2014

Source: Wellershoff & Partners

This picture differs significantly from the situation in Europe. Thanks to the Eurozone debt
crisis, many stock markets particularly those in southern Europe got shunned by investors
and valuations became increasingly attractive. Exhibit 2 shows the development of the fair
Shiller-PE and the actual Shiller-PE for the four major stock markets in the Eurozone:
Germany, France, Italy and Spain. As we can see from the example of Germany and France,
valuations were attractive after the end of the financial crisis but recovering quickly. When
the Eurozone debt crisis reached its first climax in summer 2011, valuations dropped sharply
in almost all markets. Once the European Central Bank and its governor Mario Draghi
managed to calm down investors with their whatever it takes announcement and once the
austerity measures taken in different countries started to show results, equity markets could
recover and consequently the valuation gap in most countries started to narrow again. At the
end of September 2013 German stock markets show a Shiller-PE that is roughly fair when
compared to a macroeconomically derived Shiller-PE while France and Italy still show rather
low valuations. With its stunning performance during the summer, Spanish equities are now
becoming somewhat of a place of exuberance again.

Exhibit 2: Fair Shiller-PE derived from macroeconomic variables and current Shiller-PE for
four European stock markets
Germany

France

20

18

18

ShillerPE

ShillerPE

Fair ShillerPE
Current ShillerPE

16
14
12
07/2010

16
14
12
10

07/2011

07/2012

07/2013

07/2010

07/2011

Italy

07/2012

07/2013

07/2012

07/2013

Spain

16

12
ShillerPE

ShillerPE

14
12
10

10
8

8
6

6
07/2010

07/2011

07/2012

07/2013

07/2010

07/2011

Source: Wellershoff & Partners

In Exhibits 3 and 4 we show the current Shiller-PE in comparison to our fair Shiller-PE for
all the countries in our sample. All the data was calculated as of 30. September 2013.
Exhibit 3: Current Shiller-PE and macroeconomically derived Shiller-PE for developed
markets
Developed
markets

Current Shiller-PE

Australia
Austria
Belgium
Canada
Denmark
Finland
France
Germany
Hong Kong
Ireland
Italy
Japan
Netherlands
New Zealand
Singapore
Spain
Sweden

15.4
10.7
12.2
17.9
21.4
13.3
12.9
15.0
16.6
15.0
8.0
21.2
12.0
16.6
14.3
7.9
15.6

Fair Shiller-PE
derived from
macroeconomic
variables
14.8
7.2
14.9
24.7
18.9
6.4
21.1
14.4
15.5
10.0
15.2
30.6
14.4
15.5
14.2
6.6
18.9

Deviation of
current Shiller-PE
from fair ShillerPE in %
4.1
48.6
-18.1
-27.5
13.2
107.8
-38.9
4.2
7.1
50.0
-47.4
-30.7
-16.7
7.1
0.7
19.7
-17.5

Switzerland
UK
USA

18.4
12.7
22.4

16.0
13.2
13.3

15.0
-3.8
68.4

Source: Wellershoff & Partners

Within developed markets, the best opportunities can still be found in Europe with Italy,
France, Belgium and the Netherlands amongst the most attractively valued. But when we
compare the current Shiller-PE with our fair value for the Shiller-PE other countries like the
UK, Canada or Australia show valuations that seem to be at least in-line with current
economic conditions.
In the emerging markets the picture is somewhat more confusing, but in general we can say,
that most Asian markets like Malaysia, India or Thailand show valuations significantly above
the fair Shiller-PE and many countries in Eastern Europe showing fair to cheap valuations.
Exhibit 4: Current Shiller-PE and macroeconomically derived Shiller-PE for emerging
markets

Emerging markets

Fair Shiller-PE
derived from
macroeconomic
variables
10.1
5
9.5
13.9
14.5
14.6
19.7
28.2
25
13.4
9.5
15
8.5

Current Shiller-PE

Brazil
Greece
Hungary
India
Korea
Malaysia
Mexico
Peru
Philippinnes
Poland
Russia
South Africa
Thailand

10.1
4.8
9.6
16.7
14.3
20.4
19.2
17.1
20.7
13.5
7.3
18.0
14.7

Deviation of
current Shiller-PE
from fair ShillerPE in %
0.0
-4.0
1.1
20.1
-1.4
39.7
-2.5
-39.4
-17.2
0.7
-23.2
20.0
72.9

Source: Wellershoff & Partners

A look into the future: expected returns
Of course, comparing the current Shiller-PE with a theoretical fair Shiller-PE derived from
macroeconomic variables is of limited use to the practitioner. The more important analysis is
to derive reliable return forecasts for different equity markets for the coming years. In
Exhibits 5 and 6 we show the projected real returns (after inflation) for developed and
emerging markets based on our panel regression methodology introduced last year (Klement
[2012a, 2012b]). We have calculated both expected real returns for the coming 5 years using

non-overlapping periods of 5 years and for the coming 10 years using non-overlapping
periods of 10 years. All data is calculated as of end of September 2013. We note that since we
use a panel regression to estimate future real returns some countries may experience shifts in
expected returns that are larger or smaller than the shifts that can be expected based on last
years equity market performance alone. The advantage of our estimation methodology is that
it reflects the comovement effects between different global equity markets and thus leads to a
forecast that is consistent across countries based on their current valuations and historic
correlations.
The main conclusions from our analysis can again be separated into the good, the bad and the
ugly:
The good:

Expected returns for developed equity markets have declined somewhat compared to last
year due to the strong performance of stock markets. For global developed markets
estimated real returns for the next five years have declined by about 1% to 2% per year
and by about 0.5% to 1% per year for the next ten years. However, on an absolute level,
our projected real returns are still rather high for developed markets and with the notable
exception of the United States real returns over the next five years should remain in the
high single digits.

European equity markets remain by far the most attractive markets in the world.
Particularly France, Italy and Spain, but also some smaller European countries like
Austria or Belgium promise exceptionally high real returns over the next five to ten years.

Due to their underperformance vs. developed markets, emerging market stocks have
become more attractive on a relative basis. Expected returns for emerging markets are
still below most developed markets but at least for a ten-year investment horizon they
have become comparable to developed markets again.

The bad:

The United States remains one of the most overvalued stock markets in the world and
expected real returns have declined even more compared to last year. Currently we expect
an average annual real return of 2% to 2.5% for US equities over the next 5 to 10 years.

Amongst emerging markets, many Asian markets still have low expected returns. In
particular regional heavyweights like Korea or Thailand have rather low expected returns.

The ugly:

Some smaller emerging markets like the Philippinnes or Poland still have negative
expected real returns over a five-year investment horizon. Despite its very low Shiller-PE,
Russian equity markets also have negative expected real returns. The result for Russia
should be taken with a grain of salt, though, since it is based on an extremely short data
sample.

Exhibit 5: Estimated real returns five and ten years ahead for developed markets
Developed
markets

Current Shiller-PE

Cumulative 5-year
real return in %

15.4
10.7
12.2
17.9
21.4
13.3
12.9
15.0
16.6
15.0
8.0
21.2
12.0
16.6
14.3
7.9
15.6
18.4
12.7
22.4

40.3
126.2
71.2
23.7
39.7
25.8
72.7
37.7
62.6
7.1
89.4
36.9
50.9
37.4
53.2
94.2
72.3
34.4
27.1
10.6

Cumulative 10year real return in

%
73.4
65.2
100.4
50.4
86.1
77.6
108.2
66.2
111.0
29.8
160.6
62.1
93.5
41.7
83.1
45.4
124.4
70.1
55.3
28.2

19.7

45.2

84.4

15.2

68.7

114.1

Australia
Austria
Belgium
Canada
Denmark
Finland
France
Germany
Hong Kong
Ireland
Italy
Japan
Netherlands
New Zealand
Singapore
Spain
Sweden
Switzerland
UK
USA
Developed Markets
Value Weight
Developed Markets
Equal Weight

Source: Wellershoff & Partners

Exhibit 6: Estimated real return in the next five and ten years for emerging markets
Emerging markets

Current Shiller-PE

Cumulative 5-year
real return in %

10.1
17.1
16.5
28.0
4.8
9.6
16.7
20.5
14.3
20.4
19.2
17.1
20.7
13.5
7.3
18.0
14.7
14.5

27.3
55.9
87.2
89.8
182.8
105.6
101.2
55.9
22.3
41.0
66.2
174.9
-19.4
-4.9
-2.3
11.3
14.2
61.0

Cumulative 10year real return in

%
98.2
106.1
n.a.
n.a.
123.2
78.4
100.5
49.8
35.2
70.2
123.7
204.0
-23.0
43.4
4.3
58.0
4.3
92.6

15.7

35.9

109.2

16.9

41.3

81.0

Brazil
Chile
China
Colombia
Greece
Hungary
India
Indonesia
Korea
Malaysia
Mexico
Peru
Philippinnes
Poland
Russia
South Africa
Thailand
Turkey
Emerging Markets
Value Weight
Emerging Markets
Equal Weight

Source: Wellershoff & Partners

The Shiller-PE and interest rates
Some of our readers have remarked, that the high Shiller-PE in the United States can be
justified by the extremely low interest rates. Low nominal interest rates should lead to an
increase of valuations because future earnings are discounted at a lower rate and thus worth
more today. Current prices should reflect this higher present value of future earnings and thus
valuation metrics like the Shiller-PE should have increased during the last couple of years. As
we have written in last years report, we find that on average, lower inflation leads to a higher
Shiller-PE and lower real interest rates lead to a lower Shiller-PE. Since both inflation and
real interest rates have been exceptionally low since the financial crisis it is unclear which
effect is going to win.
We thus ran regressions of the Shiller-PE in each country in our sample on the current level
of interest rates as well as the change in interest rates over the previous 10 years. For each
country we use local 10-year government bond yields as proxy for the prevailing interest rate
environment.

We thus run regressions of the form:

!,! = !,! 10!,! + !,! _10!,! +
where Y10i,t denotes the 10-year nominal government bond yield of country i at time t and
DELTA_Y10i,t the change in government bond yields in the ten years up to time t. Exhibit 7
shows the results of these regressions for the countries in our sample.
Exhibit 7: The Shiller PEs dependence on interest rates
Developed
markets
Australia
Austria
Belgium
Canada
Denmark
Finland
France
Germany
Hong Kong
Ireland
Italy
Japan
Netherlands
New Zealand
Singapore
Spain
Sweden
Switzerland
UK
USA
Emerging
markets
Greece
Hungary
India
Korea
Malaysia
Mexico
Philippinnes
Poland
Russia
South Africa
Thailand

Y10 i,t

DELTA_Y10 i,t

const

Adj. R 2

-0.77***
5.99***
0.12
0.99***
0.59***
12.09***
0.62**
-0.24
3.88***
1.42***
-1.82***
-1.55***
-0.32
1.38***
1.98***
0.74*
1.12***
-0.75*
-0.18***
0.50***

-0.31***
-1.79***
-0.87***
0.46*
-0.23
-5.52***
-0.14
-2.51***
-1.15***
-1.64***
-0.35***
-2.75***
-1.79***
0.386***
0.17
-1.49***
-2.45***
-1.72***
-0.90***
-1.69***

24.41***
-5.93***
13.78***
14.26***
13.85***
-37.70***
14.04***
16.12
5.03***
4.41**
23.81***
37.42***
14.09***
9.97***
10.58***
7.73***
8.50***
21.20***
16.27***
13.85***

0.41
0.57
0.21
0.09
0.05
0.60
0.02
0.16
0.59
0.42
0.29
0.15
0.19
0.15
0.27
0.54
0.47
0.10
0.59
0.26

Y10i,t

DELTA_Y10i,t

const

Adj. R2

0.92***
0.46*
1.25***
2.53***
3.29***
-1.47***
-1.75***
0.03
-1.14**
-0.18***
2.04***

-0.84***
-1.72***
-0.76***
-0.83***
-3.02***
0.76***
0.22**
-0.81***
0.01
-0.50***
-0.90***

4.35**
8.78***
10.11**
5.02***
1.50
26.11***
33.12***
12.03***
22.10***
15.49***
-0.69

0.25
0.46
0.04
0.68
0.21
0.51
0.54
0.64
0.06
0.52
0.30

Source: Wellershoff & Partners;

Note: *, **, *** denote statistical significance at the 10%, 5% and 1% levels, respectively.

The results of our analysis are two-fold. First, it is important to notice that a low current level
of interest rates does not necessarily lead to a high current Shiller-PE. In some countries this
is true, but in other countries most notably in the United States an environment of low
interest rates was typically accompanied by low Shiller-PEs.
Second, changes in interest rates often are more important than levels of interest rates. Here it
is particularly important to realize that in almost all countries falling interest rates lead to a
higher Shiller-PE. During the last 10 years we have seen interest rates drop to historic lows in
most developed nations. Of course it is impossible to tell, where interest rates will be in 10
years from now. But given the current level of interest rates, it seems safe to say that most
likely we will not witness another decade of declining interest rates. As the secular trend for
interest rates turns, equity markets around the world will feel an increasing headwind from
rising interest rates that should manifest itself in declining Shiller-PEs.
This negative influence of rising interest rates on the Shiller-PE and expected equity market
returns is not reflected in our projected returns for the coming 5 or 10 years, because these are
based on regressions over the entire historical sample and thus implicitly assume that interest
rates are held at average historic levels. Thus, it may well be that our projected returns are
somewhat too optimistic.
Conclusions
We have investigated the expected real returns for 38 equity markets around the world based
on their current Shiller-PE at the end of September 2013. We find that expected real returns
are somewhat lower than a year ago, which shouldnt surprise anyone given the strong
performance of equity markets over the last 12 months. The main trends in equity markets
remain intact. European equity markets still are the most attractive equity markets around the
world, while the US equity market is significantly overvalued. Thus, investments in US
equities are likely going to disappoint investors in coming years. Emerging market equities
have become somewhat more attractive and at least over longer investment horizons promise
similar returns as developed markets. The individual differences between countries are still
significant, though, and a selective approach might well pay off.
Finally, over the coming 5 to 10 years we have to expect significant headwinds from rising
interest rates that might diminish the expected returns shown here. As central banks start to
unwind their current policies of quantitative easing and eventually should raise interest rates
again we have to expect, that these developments might potentially lead to significant a
correction in equity markets.
10

Bibliography

Klement, J. Does the Shiller-PE Work in Emerging Markets?, Available at SSRN:

http://ssrn.com/abstract=2088140, (2012a).
Klement, J. What the Shiller-PE says about Global Equity Markets, Critical
Perspectives, (2012b).

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