A Must-Read for New Investors: How a Nobel Laureate Dynamically Adjusts the Equity Weight in a Portfolio

This question stands shoulder to shoulder with “Which stock should I buy?” as one of the biggest dilemmas for investors.
Cutting your equity allocation makes it feel like your assets don’t grow in a bull market, but increasing it makes downturns unbearably stressful. You may even start to wonder whether the portfolio you set up has any real meaning at all.

Many investors struggle with exactly this experience. In particular, it often happens because they fail to grasp when to adjust their portfolio—that is, the right timing for rebalancing. Blindly tweaking allocations based on gut feelings about the market can be dangerous.

There is an economist who offers a clear answer to this concern: Professor Robert Shiller, winner of the 2013 Nobel Prize in Economic Sciences. He is renowned for his research on market inefficiencies and investor psychology, and he developed indicators that are particularly useful for assessing whether the market is overvalued or undervalued from a long-term perspective. The indicator we will look at today is ECY (Excess CAPE Yield). Before we dive into ECY, however, we need to understand a concept that predates it as a market valuation gauge: the CAPE (Cyclically Adjusted Price Earnings) Ratio, better known as the “Shiller P/E ratio.”

Cyclically Adjusted Price Earnings refers to the price-to-earnings ratio adjusted for the business cycle.

Business cycle… adjustment… price-to-earnings… If your eyes are already glazing over, let’s start with the basics of the price-to-earnings ratio (P/E). It is the current share price divided by a company’s net income over the past year.
What you learn by dividing price by earnings is this: if the P/E is high, the stock is expensive; if it is low, the stock is cheap. Just as you would compare the price of a goose with the value of the golden eggs it will lay before deciding whether to buy it, comparing a stock’s price with the company’s net income is one reasonable way to decide whether to purchase that stock.

Here, Professor Shiller pointed out that P/E can swing wildly with short-term earnings fluctuations, because it is based on a company’s net income over just the past year. For example, if a temporary recession reduces corporate profits, the P/E will rise and make stocks look more expensive than they really are. Yet that moment might actually be an attractive entry point for long-term investors.

So Shiller instead used a method that takes corporate net income over the past 10 years, adjusts it for inflation, and then divides the current share price by this 10-year average. You can think of it as evaluating a student’s ability based on a 10-year grade average.

Professor Robert Shiller stresses that humans are not inherently rational decision-makers and that investment decisions are strongly affected by emotions and psychology, underscoring the importance of behavioral economics.
He also emphasizes that predicting short-term market movements is extremely difficult because there are simply too many variables. That is why he argues that an investment strategy that reads the market’s long-term trends and takes advantage of irrational booms and busts can be effective.

Think of it like a weather forecast: it’s hard to predict whether it will rain tomorrow, but you can predict the change of seasons.

We now know that when the Shiller PE ratio is high, the stock market is overvalued, and when it is low, the market is undervalued.

As of April 2025, the Shiller PE ratio stands at 31.8, while the long-term average is 17.6.
Recent declines driven by Trump’s tariff policy, concerns about an AI bubble, and so on may remind investors of the COVID crash, yet the Shiller PE ratio is still far above its historical average.
Does this mean we’re on the brink of a massive crash and should immediately dump all our stocks, portfolio construction be damned?

It’s too early to sell everything. The Shiller PE ratio has a tendency to trend upward over the long term.

There are several possible reasons why the Shiller PE ratio tends to rise over time. One major factor is the long-term downtrend in interest rates. As interest rates fall, the present value of future earnings increases, so investors become willing to pay a higher price for the same level of earnings. This pushes overall stock market valuations higher and can drive up the Shiller PE ratio. In addition, structural changes in the economy—such as the growth of the services and technology sectors—may have boosted corporate profitability compared with the past, which can also contribute to a higher Shiller PE.

When Professor Shiller first introduced his metric, he argued that a higher number meant stocks were expensive. But as the indicator kept drifting higher over time, that must have been frustrating—even though he’s not exactly a perma-bear.
So Shiller introduced something new: ECY, short for Excess CAPE Yield.

Put simply, you can think of ECY as an indicator that shows “How much more attractive is risky stock investing compared with safe bond investing?” It’s like measuring the “extra thrill” you get from riding a scary roller coaster instead of a gentle ride. Because stock investing is riskier than bond investing, we naturally expect higher returns from stocks than from bonds. ECY captures exactly this difference in expected returns.

ECY is calculated as follows:

When we compare ECY with the subsequent 10-year annualized excess returns, we can see that the two series move in a strikingly similar pattern.

This suggests that ECY can serve as a reliable benchmark for gauging how much better the stock market is likely to perform than the bond market over the long term.
In other words, when ECY is high today, it can be interpreted as a higher probability that stocks will outperform bonds over the next 10 years. Conversely, when ECY is low, expected returns on stocks and bonds are likely to be similar, or the relative appeal of stocks may be weaker.

We’ve established that ECY is an indicator of how attractive stock investing is. The next question is: what should we compare ECY against to build an investment strategy? The answer is the 10-year Treasury yield. In particular, the 10-year U.S. Treasury yield is the most widely referenced benchmark for safe asset returns globally.

By comparing ECY with the Treasury yield, we can think about the following types of investment strategies:

If you’ve previously kept stock and bond weights fixed and failed to respond adequately to changing market conditions, an asset allocation strategy built around ECY may offer a compelling alternative.

The key point is that ECY goes beyond simply judging whether the equity market itself is overvalued or undervalued; it can help you dynamically adjust portfolio asset weights by comparing the relative attractiveness of equities versus safe assets.

It is not healthy to try to forecast the stock market solely by looking at indicators. It must be accompanied by an understanding of risk and expected return, and I would emphasize that our ultimate investment objective should be trades based on the attractiveness of assets, not trades aimed merely at realizing price differences.

*You can compare ECY and Treasury yields here.