Monday, 28 April 2014

Predicting The Next Market Crash Using Shiller P/E Ratio

An interesting topic to blog about when it come to searching different kinds of indicator to predict the next market crash. Well in this post, I intend to introduce another famous indicator used by many analysts...

What is Shiller P/E Ratio?
The Shiller P/E was invented by Prof. Robert Shiller of Yale University to measure the market's valuation.

How Shiller P/E Ratio is Calculated?

Why use Shiller P/E Ratio instead of normal P/E Ratio?

The Shiller P/E Ratio is deemed a more accurate indicator as it eliminates fluctuation of the ratio caused by the variation of profit margins during business cycles. 

Read more about P/E Ratio as an indicator HERE.

Why Normal P/E Ratio is an inaccurate indicator?
  • During economic expansions, companies have high profit margins and earnings. The P/E ratio then becomes artificially low due to higher earnings. 
  • During recessions, profit margins are low and earnings are low. Then the regular P/E ratio becomes higher
Case Study : 2008 Financial Crisis

The above graphical illustration contains the historical price of the S&P 500, values of Shiller P/E and values of Regular P/E from the 1st of June 2004 to 28th of April 2014.

Predicting the Peak and Impending Crash of 2008
At the peak of S&P 500 on Oct 8, 2007 as indicated by the red vertical line, the Shiller P/E value of 26.70 at that time was 61.8% above the its historical mean of 16.5. This was a clear indication that the market is at a boiling point. 

On the other hand, the Regular P/E value of 19.0 during the same period (which was close to the historical mean of 15.8) provided no clear signs that a crash was imminent. 

Predicting the Bottom and Recovery of 2008 Financial Crisis
Looking at the black vertical line in the above illustration, you can see that at the lowest point of the S&P 500, the Shiller P/E also indicate a value of 13.3 or -19.4% below the historical mean. The Shiller P/E clearly indicate that it was the right time for investors to return to the stock market. 

What's about present day? 
  • As of 28th April 2014, the Shiller P/E is at 25.10
  • Or 52.12% above the Average Mean of 16.5
  • Updated daily Shiller P/E can be found HERE
Is this a sign that the Stock Market is about to crash?
In my personal opinion, the above average Shiller P/E value serves as an early warning for investors investing in the equity market. Despite the high Shiller P/E value, I'm believe that the market is not about to crash just yet as other indicators are not pointing to that direction.

Never the less, all equity investors should start monitoring the major indicators closely as decide what's best for their investment. Perhaps it is a good time to take profit and diversifying your gains into other investment opportunities which are non-equity related?

Find out what other indicators to help you predict the next crash:
Cheers and Happy Investing!

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