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IN THE ONGOING battle between those who believe that the stock market is in a bubble and those who don’t, you may have heard mention of something called CAPE, short for cyclically adjusted price-earnings ratio. Among market indicators, it has the strongest track record in predicting future market returns.
What does the CAPE ratio say about today’s market? It’s flashing red. According to CAPE, the U.S. stock market is more overpriced today than it has been at any time since the 2000 market peak. And other than that brief period, which didn’t end well, the ratio—which incorporates data going back 140 years—has never been higher.
Should you be concerned? Before I get into that question, some background: CAPE grew out of a 1988 study by Robert Shiller, a Yale University professor and Nobel laureate, and fellow economist John Campbell. Owing to both its pedigree and its track record, the CAPE ratio is highly respected.
CAPE is similar to a traditional P/E, or price-earnings, ratio in that it provides a measure of how expensive stocks are. If you aren’t familiar with the concept, a P/E ratio compares a company’s share price to its earnings. It might tell you that a company’s stock is trading at, say, 25 or 30 times the company’s per-share earnings.
The “E” in a traditional P/E ratio is the company’s earnings over the past year or its expected earnings over the coming year. While that’s generally a useful measure, it’s subject to distortion because companies can have anomalous years from time to time—2020 being a perfect example. Shiller’s solution to this problem was to use not one year of corporate earnings, but a company’s average earnings over 10 years.
The CAPE has logical appeal. It’s also been proven. A Vanguard Group study found that the CAPE ratio had the strongest ability to predict market returns among 15 different metrics it tested.
It’s for these reasons that adherents of the Shiller P/E take it so seriously—and get so concerned when it’s running hot. But sometimes, in my opinion, its supporters get a little carried away, exaggerating its significance and overlooking potentially important nuances.
On that score, it was interesting to see Shiller himself weigh into the debate in a recent opinion piece. His opening line: “The stock market is already quite expensive.” But then, in an apparent contradiction, he went on to say, “But it is also true that stock prices are fairly reasonable right now.”
This is how Shiller explained the contradiction: Yes, the U.S. stock market is expensive by historical standards. It’s also the most expensive among the 26 countries he tracks. Shiller cautioned, however, that investors shouldn’t look at stocks in a vacuum. All investments need to be considered as part of a continuum of investment options. And, on a relative basis, stocks aren’t expensive—because bonds are expensive, too.
You might ask why this is relevant. If one asset is overpriced, does it matter if another one also is? For instance, if a Rolls-Royce is overpriced, I really don’t care if Bentleys are, too. That just means they’re both overpriced.
I understand that argument, but Shiller makes a good point. The relative valuation of assets is relevant because you need to store your money somewhere. That’s why I think Shiller makes a fair point in saying that investments—even expensive investments—need to be considered on a relative basis, compared to the other available options.
To facilitate these comparisons, Shiller and two colleagues recently developed a modified version of CAPE that functions as a relative measure. Called the Excess CAPE Yield, or ECY, this new metric measures “the premium an investor might expect by investing in equities over bonds.” In other words, it answers this question: Relative to bonds, how attractive are stocks?
What’s the answer? As of March 5, when Shiller’s piece was published, the ECY was right in line with its 20-year average, meaning that stocks were—relative to bonds—no more expensive than their historical average. More important, if you had to choose, stocks were more attractive. The reason: With stocks, Shiller notes, “at least there is a positive long-run expected return.”
In the weeks since Shiller’s article was published, bond yields have risen, making stocks a little less attractive according to the ECY. But stocks still remain more attractive than bonds by this measure. What should you make of all this? I see three useful takeaways for individual investors:
1. Investments should always be evaluated as part of a continuum and relative to the available alternatives. It’s true that U.S. stocks might not look ideal right now, but you can only compare them to the set of available alternatives—not to the alternatives we wish we had.
2. As I’ve noted before, investment valuation is a lot like a Rorschach test. It really depends on how you choose to look at things, so don’t let anyone—or any ratio—unduly influence you. Look around, and you’ll find leading names in finance—from Jeremy Grantham to Ray Dalio to Mohamed El-Erian—holding forth. My advice: Don’t entirely ignore them, but don’t view their opinions as pronouncements from Sinai. Shiller himself acknowledges that the CAPE ratio, despite its good reputation, still only explains about a third of the market’s actual returns, making market forecasting as much art as it is science. In his words, “I wish my measurements provided clearer guidance, but they don’t.”
3. Because none of us really knows which way things will go, I believe the only and best strategy is to hold a simple, well-diversified portfolio. It doesn’t need to be any more complicated than that.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, he advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman and check out his earlier articles.
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Nice article. Thank you.
Well said.
Investing is a simple game. See the market portfolio. Buy the market portfolio. Hold a few bond funds.
Sometimes you win. Sometimes you lose. Sometimes it rains.
;>)
Agree you should avoid extreme reactions to high valuations. But some investors and commentators seem to have entered the land of wishful thinking. I’m close enough to retirement age I’d rather not pay ‘too much for the whistle’.
And since the industry has decided to leave out of PE calculations any company which has negative earnings, for some indexes even applying CAPE gives a flawed sense of value. Many international indexes are no longer cheap but are not as high as their US counterparts.
Nice article, Adam. You do a great job of distilling complicated topics for the reader. I was taught to ask the question “Compared to what?”. This is useful in many parts of life, but Shiller’s article really shows its value.