May 2, 2015 3:08PM # Contra Shiller: Stock P/E Ratio Depends on Bond Yields, Not Historical Averages By [Alan Reynolds](https://www.cato.org/people/alan-reynolds) --- SHARE *The Wall Street Journal* just offered two articles in one day touting Robert Shiller’s cyclically adjusted price/​earnings ratio ([CAPE](http://blogs.wsj.com/totalreturn/2015/05/01/valuing-foreign-stock-markets-by-the-shiller-pe/)). One of then, “Smart Moves in a Pricey Stock Market” by [Jonathan Clements](http://blogs.wsj.com/totalreturn/2015/04/30/smart-moves-in-a-pricey-stock-market/), concludes that, “U.S. shares arguably have been overpriced for much of the past 25 years.” [Identical warnings](https://www.cato.org/publications/commentary/shilling-shiller-permabear-press) keep appearing, year after year, despite being endlessly wrong. The Shiller CAPE assumes the P/E ratio must revert to some heroic 1881–2014 average of 16.6 (or, in Clements’ account, a 1946–1990 average of 15). That assumption is completely inconsistent with the so-called “Fed model” observation that the inverted P/E ratio (the [E/P ratio](http://www.investopedia.com/articles/investing/120513/comparing-pe-eps-and-earnings-yield.asp) or earnings yield) normally tracks the 10 year bond yield surprisingly closely. From 1970 to 2014, the average E/P ratio was 6.62 and the average 10-Year bond yield was 6.77. ![Media Name: inverted_p-e_ratio_tracks_bond_yield.jpg](/sites/cato.org/files/styles/pubs_2x/public/wp-content/uploads/inverted_p-e_ratio_tracks_bond_yield.jpg?itok=KrkG4LPN) When I first introduced this “Fed Model” relationship to Wall Street consulting clients in “The Stock Market Like Bonds,” [March 1991](https://www.cato.org/blog/reynolds-model-stock-prices), I suggested bonds yields were about to fall because a falling E/P commonly preceded falling bond yields. And when the E/P turned up in 1993, bond yield obligingly jumped in 1994. Since 2010, the E/P ratio has been unusually high relative to bond yields, which means *the P/E ratio has been unusually low*. The gap between the earnings yield and bond yield rose from 2.8 percentage points in 2010 to a peak of 4.4 in 2012. Recylcing my 1991 analysis, the wide 2012 gap suggested the stock market thought bond yields would rise, as they did –from 1.8% in in 2012 to 2.35% in 2013 and 2.54% in 2014. On May 1, the trailing P/E ratio for the S&P 500 was 20.61, which translates into an E/P ratio of 4.85 (1 divided by 20.61). That is *still high* relative to a 10-year bond yield of 2.12%. If the P/E fell to 15, as Shiller fans always predict, the E/P ratio would be 6.7 which would indeed get us close to the Shiller “buy” signal of 6.47 in 1990. But the 10-year bond yield in 1990 was **8.4%.** And the P/E ratio was so depressed because Texas crude jumped from $16 in late June 1990 to nearly $40 after Iraq invaded Kuwait. [Oil price spikes](https://www.cato.org/publications/commentary/recessions-import) always end in recession, including 2008. Today’s wide 2.7 point gap between the high E/P ratio and low bond yield will not be closed by shoving the P/E ratio back down to Mr. Shiller’s idyllic level of the 1990 recession. It is far more likely that the gap will be narrowed by bond yields rising. [![Creative Commons License](/build/cato_2020/images/creative-commons.svg)](http://creativecommons.org/licenses/by-nc-sa/4.0/) This work is licensed under a [Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License](https://creativecommons.org/licenses/by-nc-sa/4.0/).