What Today's CAPE Ratio Tells Us About the Future of the Market

The CAPE ratio, or Shiller P/E ratio, is at about 30 today. This is almost twice its historical median of 15.93 dating back more than 140 years. This elevated number suggests that stocks in the S&P 500 are expensive relative to their earnings.

As a valuation measurement, the CAPE ratio compares the price of a stock to the average of the company’s earnings over the last ten years. By using ten years of earnings figures, the calculation smooths out cyclical profit fluctuations that might otherwise distort the true picture of the business. Today, that picture might be darkening.

Consider that the S&P 500 CAPE ratio has signaled an overvaluation - defined here as 24.05 or more - before every market decline since 1998 based on the average S&P 500 CAPE ratio since 1950. The selected overvaluation figure of 24.05 is simply a 20% increase on the CAPE S&P 500 long-term average of 20.04.    

Does today’s comparatively high CAPE ratio suggest a steep drop in the equities market is ahead?

Source: MacroMicro

Can the CAPE Get it Wrong?

The CAPE ratio is not without flaws. The most common criticism of the metric is that it’s backwards-looking.

This characteristic is especially problematic today because markets appear to be headed into territory not seen for at least 40 years. In fact, Morgan Stanley is calling this the “dawning market cycle.” They describe the possibility of a new setting in which “decarbonization and deglobalization, among other factors, create incentives for increased capital investment. Inflation normalizes closer to 3%, and rates remain higher for longer.”

Some economists have even speculated that we’re headed for a period of “financial repression” in which the government creates a level of nominal growth and inflation that exceeds interest rates in an effort to reduce the debt-to-GDP ratio. You can read more about the implications of this dynamic here. If this new market is upon us then the backward-looking CAPE may prove less reliable.

Another criticism is that the ratio uses numbers that rely on GAAP (generally accepted accounting principles) which have changed several times over the decades. Therefore, the measurement is not perfectly standardized over the years.

Despite these drawbacks, it’s hard to ignore the connection between a high CAPE and major market downturns.

Source: Multpl

Where Does the Market Go from Here?

What makes the current CAPE ratio so intimidating is the fact that it’s so close to reaching 30. Historically, when the ratio exceeds this number, the market suffers considerably. The ratio has only passed 30 on six occasions since 1870. In the last five of these instances, the S&P 500 or broader market lost 20% of its value eventually. This happened in 1929, 1997, 2018, 2019, and 2022. These periods represent some of the most disastrous moments for the market ranging from Black Tuesday, to the dot-com bubble, to the Covid-19 pandemic. The most recent instance of the CAPE ratio surpassing 30 was in February of this year.

Moreover, this is not just a US phenomenon. For example, researchers have examined the predictive power of the CAPE ratio when applied to the FTSE/ASE Large Cap Index and concluded that “the CAPE ratio appears to be a good estimator of future returns of the FTSE/ASE Large Cap Index.” The researchers also note that “the relationship between the CAPE and future returns appears inversely proportional, that is, the higher the ratio, the lower the expected future returns.”

The challenge for most investors is gauging the amount of time between when the CAPE ratio flashes red and when the market actually plummets. Since 1995, the time from the S&P 500 peak to trough ranged from 13 days in 2018, to just over 30 months between 2000 and 2002.

In fact, the amount of time between the signal, the peak and the trough of the S&P 500 can test the patience of the most stalwart investors. This was the case in 2013 and 2016.

2013

Signal: 11.30.2013

Peak: 05.21.2015

Trough: 02.11.2016

2016

Signal: 03.31.2016

Peak: 01.26.2018

Trough: 02.08.2018

While the CAPE ratio is not a perfectly reliable indicator and cannot forecast the onset of the next drop, the current number, nearing 30, should give investors pause for thought. Now is the time to reevaluate how well a portfolio is positioned to weather the next storm. 

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc. or Trackinsight. Past performance is not indicative of future results. Investors should undertake their own due diligence and carefully evaluate companies before investing. ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED.

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