Q. So we all know about the basic Price/Earnings ratio, but the “Schiller PE” is version that a lot of market pros actually prefer… how is it different?
A. It’s in how you compute the “E”. The standard P/E divides the S&P price by those stocks’ trailing 12-month earnings, and the historic average is something around 15. The Shiller version takes an average of the last 10 years earnings, adjusted for inflation, as the denominator.

Q. So it uses a much longer term measure of earnings… but what’s the advantage of that?
A. Its smoothes out the ups and downs of the business cycles. Earnings are very volatile, of course, when the economy is doing well companies make more money — so the short term PE might look artificially low in such periods, implying stocks are “too cheap”. Conversely, the one-year PE can look absurdly high after a big crash, as it did in early 2009– the PE was something like 125 for a while, so it looked like stocks were way “too expensive”… when in fact it was a good time to buy.

Q. So many people obviously think the Shiller version is more reliable because of the way its smoothes out those shorter term phenomena?
A. Yes. In that 2009 example, the Shiller PE was at about 13. And history has shown that as the Shiller rises, forward 10 year returns have fallen. So its not really a trading indicator, but a good yardstick for “where are we now” a little like the Q Ratio we discussed a couple weeks ago.

Q. Alright, then: we are we now?
A. Looking a little pricey at the moment. We up around 24, well above historical average of about 16.5, but not near its peak, 44 right before the 2000 bubble. And that’s similar to what the Q ratio is saying. For traders, maybe that doesn’t mean much, for longer term investors it just might… one way to hedge your bets might be a solid, low-fee mutual fund running a long/short strategies.