When the market becomes overvalued it is a sign to attentive investors to stop buying and think about closing positions. The more a market heats up, the more the proportion of cautious investors gives way to reckless investors and day trading / speculation. Such a runaway process does not carry on indefinitely. it will correct.
The Shiller P/E is therefore a warning to investors of an impending crash.
Shiller calculates the ratio for a given year over the proceeding 10 year period (adjusted for ). This approach helps to dampen short-term, intra-year "noise". It allows us to visualise risk and make direct comparison with market history.
Shiller calculates Price/ as follows:
1) For any given date, take the yearly of the S&P500 -0.24% -0.24% for the previous ten years.
2) Adjust for based on Consumer Price Index
3) Take the average
4) Divide current price of S&P500 -0.24% -0.24% by the average calculated above.
5) Repeat for every year in the chart
Data provided by Quandl.