In the ongoing battle between those who believe that the stock market is in a bubble and those who do not, you may have heard mention of something called the CAPE Ratio. Among market indicators, this ratio has the strongest track record in predicting future market returns.
What does the CAPE say about today’s market? In short, it’s flashing red. According to the CAPE, the U.S. stock market is more overpriced today than it has been at any other point since the market peak in 2000. And other than that brief period, which did not end well, the ratio, which incorporates data going back 140 years, has never been higher.
What does this mean, and should you be concerned? Before I get into this question, I’ll first provide some background.
CAPE stands for Cyclically Adjusted P/E. It was developed in 1988 by Robert Shiller, a Yale professor and Nobel laureate, along with a colleague. Owing to both its pedigree and its track record, the CAPE is highly respected.
The 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’re not familiar with the concept, a P/E ratio compares a company’s stock price to its earnings. Specifically, it tells you how many dollars of profit the company generates for each share of its stock. Thus, it’s a measure of how cheap or expensive the stock is.
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 a generally useful measure, it is subject to distortion because companies can have anomalous years from time to time—last year 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 ten years
The CAPE has logical appeal, but it’s also been proven. One study by the Vanguard Group found that the CAPE Ratio had the strongest ability to predict market returns among fifteen 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.
So 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. It’s expensive by historical standards, and it’s the most expensive among the 26 countries he tracks. However, Shiller cautioned 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 are not expensive. Bonds, in particular, are expensive too.
You might ask why this is relevant. If one asset is overpriced, does it really matter if another one is too? 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 does make 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 a colleague recently developed a modified version of the 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 5th, when Shiller’s piece was published, the ECY was right in line with its 20-year average, meaning that stocks were no more expensive than their historical average relative to bonds. And more importantly, if you had to choose, stocks were still more attractive. 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 the individual investor:
1. Investments should always be evaluated as part of a continuum and relative to the available alternatives. It’s true that domestic 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, the only and best strategy, in my opinion, is to maintain a simple, well diversified portfolio. It doesn’t need to be any more complicated than that.