The CAPE ratio or Cyclically Adjusted P/E ratio, popularized by Yale University professor Robert Shiller, has been cited recently as an indication that a bear market is coming. The ratio currently sits at 32.1 versus its long-term average of 16.8. According to Shiller this signals an expensive stock market. While Shiller isn’t predicting an imminent bear market, he does say investors should be aware and avoid being too complacent.
Related: FINANCIAL FORECASTING
How CAPE Works
The CAPE ratio uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in profits that take place during different periods of a business cycle. In theory, smoothing out or averaging P/E ratios over a 10-year period provides a better picture of a company’s profits that isn’t as volatile as annual P/E ratios for the same company or group of companies.
Shiller’s ratio is typically applied to the S&P 500, but it is possible to apply it to other indexes or even individual stocks. While it is generally believed to achieve smoothing P/E ratios, there are criticisms including the fact it is backward-looking and that it uses GAAP (generally accepted accounting principles). Some critics has said the CAPE ratio may be overly pessimistic due to changes in the way GAAP earnings are calculated today.
Picking An Exit Point
The fact that CAPE is currently at a level more than 15 times higher than its long-term average does not necessarily signal that investors should bail out of the market. For example, if you would have taken an exit in July 1997 when the CAPE was at 32.8 you would have missed the 60% gain the market saw over the next 3 years.
On the other hand, had you been around in September 1929 when the market peaked, you would have experienced a 77% decline immediately thereafter. The takeaway seems clear. A CAPE ratio over 32 does not necessarily signal an imminent market collapse. Instead it simply indicates that stocks are expensive.
If Not Now, When?
Analysts and experts are not unanimous about how they view the use of CAPE to signal a bear market. One methodology uses a 35-year moving average of the CAPE ratio (35MA), rather than referring to the traditional 1881-2017 long-term average. This method may smooth out or allow for changes to accounting practices, dividend policies and other parameters over time.
The current level of the CAPE ratio relative to its 35-year moving average does not point to an exit at this time, according to proponents of that methodology. They suggest that although stock prices are high, a bear market could be years away.
Related: DON’T JUST BUY WHAT YOU KNOW
Valuation Is Not A Catalyst
To say the market is expensive is a measure of implied valuation. The problem, according to some analysts, is that without fundamental analysis there’s no real research to back up the opinion.
Another way of looking at it is that the underlying reason for valuation is what creates the catalyst – not the valuation itself. This inevitably leads to a discussion of how to use tools like the CAPE ratio. Some advocate using CAPE to pinpoint where we are in an economic cycle and then look for catalysts that will either perpetuate a continuation or cause a reversal of the existing trend.