The most trusted measure of stock market value has never sent a more ambiguous signal
So, are stock prices too high or aren't they?
One of the most closely watched measure of stock market value is the cyclically-adjusted price-earnings (CAPE) ratio. Popularized by Nobel-prize winning economist Robert Shiller, CAPE is calculated by taking the S&P 500 and dividing it by the average of ten years worth of earnings. If the ratio is above the long-term average of around 16x, the stock market is considered expensive.Currently, this measure is just above 27x, a level we've seen only before stock market crashes in the 1920s, the dotcom bubble, and the global financial crisis of just a few years ago.
"We admit that historically a high Shiller P/E has often resulted in subsequent negative returns; however, this has not always been the case and there are several examples where subsequent 3-year returns surpassed 20%," Credit Suisse's Andrew Garthwaite said in a new note warning of a stock market bubble.Using a hundred years worth of Shiller's data, Garthwaite charted the observed 3-year forward returns for various levels of Shiller's PE. The red rectangle sums up the the observed 3-year forward returns when the PE was at today's levels.
As you can see, some of the returns were above 20%, some were worse than -40%, and some were just lackluster. Indeed, the range of returns have never been wider. In other words, the signal has never been more ambiguous.
The primary issue is the valuations will stay high for very long periods of time.
But actually, the lesson there is that if you combine that with a good market diversification algorithm, the important thing is that you never get completely in or completely out of stocks. The lower CAPE is, as it gradually gets lower, you gradually move more and more in. So taking that lesson now, CAPE is high, but it's not super high. I think it looks like stocks should be a substantial part of a portfolio.
In other words, don't dump stocks and hide in cash because the CAPE is at 27. Rather, buy less, be cautious, and expect lower returns for years to come.
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