Why Use P/E10?

Professor Robert Shiller came up with P/E10 as his measure of valuation. It is spectacularly successful. Its reciprocal, the percentage earnings yield 100E10/P, does the best job in predicting stock market returns and retirement financial success of all the measures that I have tested. Close contenders include the dividend yield equivalent 100D10/P and Tobin’s q.

P/E10 captures both the INVESTMENT RETURN and the SPECULATIVE RETURN of the stock market. The INVESTMENT RETURN equals the initial dividend yield plus the growth rate of the dividend amount. P/E10 or more specifically 100E10/P captures the initial dividend yield since dividends come out of (smoothed) earnings. The dividend growth rate of stocks overall (S&P500) has been remarkably stable at 5%. The SPECULATIVE RETURN reflects the effect of changing valuations. P/E10 and its reciprocal 100E10/P capture this effect as well.

A regression analysis (linear curve fit) shows that the percentage earnings yield 100E10/P estimates both Stock Returns and Historical Surviving Withdrawal Rates exceptionally well.

P/E10 or more specifically 100E10/P does a fantastic job of predicting what happens ten years from now (or even longer). What about the next year or two? It does not work in the short term. There is too much randomness for reliable prediction.

Is P/E10 usable over long periods of time? The answer is a resounding YES. You can wait twenty years on the sidelines and still be better off. It is that powerful.

Sensible use of P/E10 embraces gradually shifting stock allocations. It avoids all-in and all-out decisions. Rob Bennett named this Valuation Informed Indexing (VII or Lucky 7). It works with individual stock segments and with the stock market as a whole (S&P500).

Have fun.

John Walter Russell
June 29, 2008