Return Distributions and the Shiller P/E Ratio - By Keith C. Goddard

If the experience of the past 125 years is a relevant guide for the future behavior of U.S. stocks, an investor who is willing to hold the market index for at least three years would rationally have the following three-year expectations at any given month-end starting point:

1) An annualized return, including dividends, of around 9.5% on average.

2) Around a 15% probability of losing money over 3-years, or slightly greater than 1-in-7 odds.

3) A possibility, although very remote, of nearly tripling their money.

4) A possibility, although very remote, of losing around 80% of their money.

Nothing about this data should look surprising to an experienced investor. Indeed, something very close to this same distribution of possible market outcomes has been programmed into the financial planning software used by most professional investors for at least the past three decades

But what if this is the wrong distribution?

To address this question, I segmented the 125-year history of the market index into quartiles based on the level of the Shiller P/E Ratio as of each month-end dating back to 1884. I then measured the return distributions associated with the lowest and highest quartiles for the Shiller P/E Ratio to search for differences between the two. The difference was material!