Money and investing ultimately come down to the numbers. So, it makes sense that we have countless indices, curves, ratios and formulae designed to explain and predict the financial future. The Cyclically Adjusted PE Ratio (known as the “CAPE Ratio”) is one of these numerical crystal balls.
For the uninitiated, the CAPE Ratio is a price earnings ratio based on average inflation-adjusted earnings over the previous 10 years. You may also have heard it referred to as the PE 10, or the Shiller PE Ratio (after its creator, Yale professor Robert Shiller). The CAPE Ratio is viewed as a gold standard measurement of market valuation, and each time the Ratio has climbed above 30, the bottom has fallen out of the market.
These days, we’ve seen an increase of the CAPE Ratio to levels we haven’t seen since the dot-com collapse when the number pressed over 44. Before that, the Ratio hasn’t approached the current value since 1929, the year the Great Depression struck, when it came in at around 32.5. Today, the Ratio is at 30.49.
This leads to an important question I received from a Money Matters caller recently. The caller told me, “Wes, I saw this scary article in Marketwatch based on the work of Nobel laureate Robert Schiller. It looks like the market is in for a crash. What do you think?”
Thank you for raising this important concern, dear caller. No doubt you’re not the only one with this worry on your mind. But, fear not and read on. I hope my answer will put minds at ease.
For starters, while the CAPE ratio is certainly a legitimate indicator to watch, it is by no means designed to be a short-term indicator. This is because it takes a full 10 years of earnings into account. So, if we look at the CAPE Ratio right now, it’s still pulling earnings from 2008 and 2009, when the numbers were extremely low due to the recession and the banking crisis. When we pull in earnings data from a severe crisis time into 2017, we have to admit that things may not really be as they seem.
It’s primarily for this reason that I don’t read into the CAPE Ratio that we’re headed for 1929 all over again. Sure, there are always dozens of immediate risks that also play their role in impacting the market, and at present North Korea is certainly on that list. But I think the current CAPE Ratio exaggerates the overvaluation in this market.
Still, I do believe the market is fully valued and pricing in a tremendous amount of good news.
As a result, we seem to stand today in an economic environment where earnings are extraordinarily strong, and market gains over the next year or two are likely to be limited.
The CAPE Ratio also suggests limited returns moving forward for stocks, a prediction that’s in line with other historical measures of price to earnings. When earnings peak like they have today, this is typically the signal of the end of an economic expansion cycle, meaning the subsequent few years end up being less impressive for earnings.
Bottom line: I believe we’re in for a period of more muted returns, rather than any sort of collapse. Remember, it’s the details that create the big picture.