Applied philosophy: The Shiller P/E and S&P 500 returns revisited

US equities have ignored valuation signals in the last 12 months as a technology-led rally boosted returns. This trend has shown signs of running out of steam year-to-date as European and Chinese stocks have outperformed. At the same time, valuations have reached levels close to extremes based on cyclically-adjusted price/earnings ratios. I use the Shiller P/E as a case study to approximate expected returns on the S&P 500 for the next 10 years. Should I ignore my contrarian instincts? 

It is the end of winter and, living in Northern Europe, I sorely need a dose of sunshine. Having underperformed year-to-date, it seems to me that US equities need the sun to shine on them, too, as sentiment has begun to sour on the impact of the Trump presidency. Indeed, it is European and Chinese stocks that have led the way, unlikely as it sounds in the era of “America First” policy. Part of the reason may be their relative underweight in technology, a mild drag this year as questions arise around AI-related capital expenditure. The US dollar has also weakened in 2025 so far, which tends to coincide with EM outperformance. Will the year progress in the same vein? 

We outlined our expectations and forecasts for the year in November 2024 feeling hopeful about European and EM equities and more downbeat about Japan and the US. If the year-to-date performance continues, it would be a reversal of the trend seen in the last 12 months when US equities were among the strongest performers (Figure 5). A technology-led rally boosted the US stock market, which is the opposite of what I expected when I last published on the topic of US equities and valuations in February 2024. 

If anything, those valuations have become even richer and they are telling us the same story now as they did last year: US equities are expensive when compared to historical norms, no matter the valuation metric used. Our favoured measure, the cyclically-adjusted price/earnings (CAPE) ratio stood at 41.1x at the end of February 2025 (using the Datastream US Total Market Index), while the Shiller P/E (its inflation-adjusted equivalent) was at 37.2x, according to our estimates (Figure 1). 

To put that into perspective, these ratios were higher only during extreme market events: around the “tech bubble” between 1998 and 2002 and the recent post-pandemic market peak between 2020 and 2022. Since January 1983 (the first available data point) the CAPE was higher only 6% and the Shiller P/E 8% of the time (using monthly data). 

Of course, a logical argument would be that we are using the wrong tools to try to determine equity returns (or at least their direction) over a relatively short investment horizon. Indeed, the relationship between our CAPE and 1-year forward returns on the S&P 500 index between 1983 and 2024 is practically zero. 

However, this predictive power improves using 10-year forward returns to an R-squared of 0.78 (between 1983 and 2015). There is a similarly strong relationship using the Shiller P/E in the same period (though the R-squared drops to 0.10 using the whole history since 1881). 

Even a quick glance reveals that valuations seem to have shifted higher in the 1980s: from an average of 15.6x between 1953 and 1983 to 24.5x between 1983 and February 2025. What were considered extreme values in the first 100 years of the history of the Shiller P/E reached only in 1929, became more “normal”. Therefore, assuming no structural change in the direction of inflation and interest rates, we ought to rely on the post-1983 model to predict long-term returns on the S&P 500 (Figure 4).

It seems to me that both measures of cyclically-adjusted P/E ratios have veered close to all-time highs, and therefore it is reasonable to assume that valuations could limit US equity returns in the long term. If past relationships persist, my model suggests that annualised capital returns over the next 10 years could be around 0.5%, not just below the long-term average of 4.8% (since 1871 based on Shiller data) but underwhelming even compared to returns on cash (assuming interest rates stay above zero), though significantly higher than the -18% returns implied by Figure 1. 

Assuming the S&P 500 dividend yield stays close to the 10-year average of 1.8%, a 0.5% capital return would imply a total return of around 2.3%. This appears disappointing compared to the 9.3% annualised total return since 1871 and the 11.7% seen in the last ten years. If the dividend yield stayed close to that 10-year average, the increase in future capital returns needed to generate a 9.2% total return would require a 34% fall in the S&P 500 from the February 2025 average, taking the Shiller P/E to 24.5x (based on the historical relationship between valuations and returns since 1983).

Within equities no other region looks quite so overvalued based on CAPE (Figure 3). Having said that, apart from EM, no other region looks obviously undervalued either with CAPEs close to historical averages. The odd one out is Japan, which on the surface looks undervalued, but its average CAPE is inflated by the period around its prolonged stock market bubble and its valuations are close to the post-GFC average (a more relevant benchmark, in my view). At the same time, a comparison of yields across asset classes reveals that as of 28 February 2025 US equities have the least attractive valuations. If I found it difficult to make the case for US equities last year (see here), it is even more difficult now. Of course, the US stock market has defied gravity for a long time, and it may continue to do so, but I think valuations have reached levels that will be increasingly hard to ignore. Therefore, we remain Underweight within the Model Asset Allocation shown in Figure 8. 

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