Six years into a bull market for U.S. stocks, you may be wondering: Is the run over? The financial news is peppered with references to the stock market being overpriced and ripe for a correction, so it would be natural for an observer to worry.
I thought I would take a look at some of the data used in these predictions to see what I could learn. One of the measures often cited by those claiming the market is overvalued is the cyclically adjusted price-to-earnings ratio. This is also called the CAPE or P/E10. I call it the PE ratio’s big brother.
What is the CAPE?
In a previous post, I discussed the price-to-earnings, or PE, ratio. As a refresher, here is the basic equation:
PE = Market price/Net income
Robert Shiller, a Nobel Prize-winning professor of economics at Yale University and author of the book “Irrational Exuberance,” created the CAPE ratio. CAPE attempts to address one of the major flaws of the PE ratio: A company’s earnings (its net income) can be highly variable in the short term. To correct for this variability, the CAPE uses a 10-year average for earnings, with each year’s number adjusted for inflation. Theoretically, this reduces the volatility in the year-to-year numbers and captures at least a full business cycle’s worth of reported earnings.
Here’s the CAPE formula:
CAPE = Market price/10-year average earnings
Since the earnings figure used in this ratio covers a greater period of time, CAPE has a tendency to be much less volatile than the traditional PE ratio. It also has a higher correlation to 10-year investment returns than the standard PE does.
One of the reasons so many people view the U.S. market as overvalued is that the current CAPE is 26.7, compared with a historical average of 16.6 (since 1871). This puts the CAPE in the top 10% of readings ever recorded. This certainly seems to indicate that the U.S. market is expensive.
What do the data tell us?
I like to review source data when I read articles about these kinds of things to make a judgment as to the strength of the claim. Fortunately, Shiller is kind enough to post his data online so we can look at the information ourselves.
First, I decided to see whether elevated CAPE levels were followed by poor long-term returns. I identified every month in which the CAPE was above the current 26.7. Then I looked at the average returns 10 years later. Since 1871, the average 10-year return following a month with a CAPE above 26.7 was negative 14.75%, or about negative 1.5% per year. This does not include dividends paid over that time frame.
It certainly seems like the negative outlook for long-term returns is justified in the data. However, critics of using CAPE as a forecasting tool point to a few things:
Another thing that jumps out at me is just what a small data set this actually is. Although 144 years seems like a long time, it gives us only 1,733 monthly data points to look at. Since 1985, that number is more like 360. I’m sure these results have some statistical significance, but it is a relatively small data set to make conclusions on.
What does it all mean?
Here’s what I take away from this analysis:
This article was originally published on Nerdwallet and Nasdaq.
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