Downside Risk

Managing the Downside Risk: The Insights of the Shiller PE Ratio

I am writing about managing the downside risk because investors often do not know what to do when markets are overvalued. The risk is when valuations race ahead of fundamentals and earnings growth and as a result stocks and even more volatile alternative assets are arguably riskier. That said, I usually do not sell, but I certainly may not add to my portfolio.


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Valuations Are Elevated

Valuations are elevated. The standard price-to-earnings ratio is above 30, and the S&P 500 Index’s dividend yield is near its all-time low. It has exceeded this value three times before, followed by a bear market each time. Similarly, the Shiller PE Ratio, popularly known as the Cyclically Adjusted PE Ratio or ‘CAPE’, is above 35. This number has significance. In the modern stock market, which I define as 1970 – Present, the Ratio has only been over 35 during two other periods. A steep bear market followed both times it exceeded this value.

Can the Shiller PE Ratio Help Manage Downside Risk?

First some history about the Shiller PE Ratio. During the dotcom boom and bubble, Professor Robert Shiller popularized the Ratio he developed along with John Campbell. In his book Irrational Exuberance, published in March 2000, he examined economic bubbles and argued that equities were overvalued at that moment in time. The book was prescient as the prolonged bear market after the long run-up in market valuations started about then. This fact leads one to ask, can the Shiller PE Ratio help manage the downside risk?

History Tends to Repeat Itself

The first time the Shiller PE Ratio went over 30 was in 1929, before one of the most brutal bear markets of all time. It went over that value again during the dotcom bubble in June 1997. The Ratio then went over 40 in January 1999. It peaked in December 1999 and January 2000 at a value of approximately 42. The Ratio decreased to about 21.3 in March 2003 before rising. However, it truly bottomed out during the Great Recession when it declined to roughly 14.1.

Next, the Shiller PE Ratio nearly reached 39X in October 2021 before the post-COVID-19 bear market. Fast forward to early 2025, when the value is over 38X.

Dividend Growth Investors Should Stay the Course

Based on the above, the Shiller PE Ratio can be used to predict bear markets and to manage the downside risk. If you believe that the Ratio is predictive based on history, it would be time to lighten up on equities and possibly increase allocation to safer investments. This action would be managing the downside risk. However, is this a reasonable expectation and course of action by dividend growth investors? Not really, because we are buy-and-hold investors, not market timers. In the words of John Bogle, one should stay the course.

Managing the Downside Risk is Difficult Based on Historical Data

The Average Value is Rising

Some investors or academics do not view the Shiller PE Ratio as predictive. For one, the average has been trending up for many years since April 1982. The average value over the past 100 years is roughly 17.2. The average over the past 50 years is over 21. The average since 1989 is more than 26. So, if the Shiller PE Ratio’s average is, in fact, moving upward, then using historical data may not be sensible for managing the downside risk on equities.

Future Returns Are Correlated to the Shiller PE Ratio

That said, there seems to be a relationship between the Shiller PE Ratio and annualized inflation-adjusted or real returns in future years. The graph below is from a study by Star Capital that shows an inverse correlation between the Shiller PE Ratio and real returns in the subsequent 10 to 15-year period. 

Lower values for the Ratio indicate higher future returns, while higher values point to lower returns. This study uses all data for the S&P 500 going back to 1881. Granted, the data has a lot of variability, but the trend is unmistakable. 

Stock Market Returns with Shiller PE Ratio
Source: Star Capital

However, some discrepancies make using the Ratio problematic. Both Sweden and Denmark have relatively high returns with a CAPE Ratio of 30X or more. The R2 value is also low, meaning the relationship is not truly predictive. Next, a study by Vanguard concluded that only 43% of returns were predicted by the CAPE Ratio from 1926 – 2011.

What Does a Shiller PE Ratio of 40 Mean?

However, the relationship between the Shiller PE Ratio and actual monthly real returns seems to have gotten stronger since 1995, as shown by another study by Michael Finke. The chart below shows the relationship between the two variables from 1995 – 2020. It’s almost an inverse straight line. This study concluded that the Shiller PE Ratio can predict 90% of the variability in returns. Further, returns were within 2.74% of the returns predicted by the CAPE Ratio 95% of the time.

The chart from the Star Capital and Finke studies both suggest that a Ratio of 40 implies real returns of 0% – 2%.

Stock Marker CAPE Ratio
Source: Advisor Perspectives

Practical Aspects of Managing the Downside Risk

If you believe the results of Finke’s study, it is prudent to consider managing the downside risk in the present market. However, the chart shows that monthly returns will be positive based on a Shiller PE Ratio of 30. When the Ratio goes over 40, returns are expected to be zero or negative.

According to John Bogle’s formula, estimated total returns are the sum of earnings growth, forward dividend yield, and price-to-earnings ratio contraction or expansion. Average earnings growth is relatively constant at about 4% to 7% per year, the S&P 500’s dividend yield is near an all-time low, and the P/E and CAPE ratios have climbed. As a result, I believe the downside risk is greater than the upside risk.

That said, by examining the dotcom bubble, we observe an 18-month lag between the Ratio going over 30 and the start of the bear market. Although the Ratio can indicate overvaluation, stock prices can still increase further because of irrational exuberance. Notably, the Ratio attained a value of 30 in December 2023 implying rougher times ahead.

The Bottom Line

However, thinking about risk and asset allocation is never too early. At the start or end of a calendar year, many individual investors start thinking about rebalancing. The S&P 500 Index was up about 24.2% in 2023 and 23.3% in 2024. It has gained nearly 2% this year. The Nasdaq Composite and 100 increased even more.

Furthermore, many stocks are setting 52-week or all-time highs, and interest rates are high. The U.S stock market is trading at about 2.7+ times sales and 4+ times book. An investor who is very heavy in equities would likely move to lighten their allocation to stocks when managing the downside risk. At the very least, they may think twice before adding to their equity exposure.

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Prakash Kolli is the founder of the Dividend Power site. He is a self-taught investor, analyst, and writer on dividend growth stocks and financial independence. His writings can be found on Seeking Alpha, InvestorPlace, Business Insider, Nasdaq, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, and leading financial sites. In addition, he is part of the Portfolio Insight and Sure Dividend teams. He was recently in the top 1.0% and 100 (73 out of over 13,450) financial bloggers, as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.

2 thoughts on “Managing the Downside Risk: The Insights of the Shiller PE Ratio

  1. Great to see that a fellow dividend investor also uses CAPE ratio as a valuation tool.
    Certainly worrying to see the markets as a whole trading at such an elevated multiple.
    My approach is to focus on fundamentals at a company level and not worry too much about the broader market indices and macro situation.

    Wish You successful investing!

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