Shiller Ratio – US has concerns, but not yet in dangerous territory

Recently, there were reports that the Shiller ratio in the US markets had crossed the 40X mark for the first time since 2001. In fact, this is only the second time in the history of US markets that Shiller ratio is above 40.

What does the Shiller Ratio tell us?

Shiller Ratio is also known as Cyclically Adjusted Price Earnings (CAPE) ratio. The CAPE also considers price as the numerator and earnings as the denominator. However, the difference is that instead of regular earnings, it considers inflation adjusted earnings of last 10 years. The Shiller ratio can go up under 2 conditions. Firstly, the ratio can go up if the market price of stocks are rising, out of sync with earnings. Today, that is true of most AI/ML stocks. Secondly, Shiller Ratio can also go up sharply if the inflation is rising faster than average, which reduces the inflation-adjusted earnings. That is also a reality today.

How has the Shiller Ratio moved in the US?

If one looks at the US Shiller ratio over the last 100 plus years, the lowest level has been 4.78X in 1920 and the highest level has been 44.19X in December 1999 (at the peak of the tech boom). The average Shiller Ratio over the last 100 plus years in the US has been 17.42X, with a median of 16.13X. Whichever way you look at it, the current Shiller Ratio of 41.07X is very close to the historic peaks. At these levels of the CAPE, the downside risks are substantially higher than the upside potential in markets. If you look at the US markets post the GFC sell-off, the CAPE ratio had touched a low of 14.12X in February 2009. From that point, it has been a one-way rally to current levels.

There are striking similarities with the 1999 scenario

The reason Shiller ratio concerns are rising in the market is the similarities between 1999 and 2026. The Shiller ratio is above 40 in both cases, but that is more of a manifestation. The real similarity is in 3 underlying factors. Firstly, the rally in 1999 and 2026 has been largely driven by technology stocks. In 1999, it was about IT, media and telecom stocks. In 2026, it is more about AI/ML stocks. Back in 1999, there was substantial investments made in IT and also in telecom capacity. In 2026, billions of dollars have been invested in creating AI capacity. Above all, in both the scenarios, the ROI on these investments were not visible immediately, and that remains the biggest concern for the markets.

Shiller Ratio may not be in danger zone, yet

While the similarities between 1999 and 2026 are hard to ignore, there is one essential difference. At 41.05X CAPE, the real equity dividend yield works out to 2.44% today; and at the 1999 CAPE of 44.19X, inflation adjusted equity dividend yield was 2.26%. How does that compare with the real bond yield. In 1999, 30-year bond yields were 5.87% and inflation was 1.46%, resulting in real bond yields of 4.41%. In 2026, the 30-year bond yields are at 5.64% and inflation is at 3.40%, resulting in real bond yields of 2.24%. That is the difference. In 1999, real bond yields were substantially higher than equity yields, leading to the sharp fall. In 2026, they are at par. It is a concern, but not a crisis still!