The CAPE ratio, based on average company earnings, is a widely watched valuation metric. Its high level suggests lower returns for U.S. stocks over the coming years. Should you believe that? If so, what actions are worth considering?
What Is The CAPE?
Nobel-prize winner Robert Shiller devised the CAPE ratio in 1988 as a tool for market valuation. It compares stock prices with average earnings over the past decade. That approach is argued to avoid being too pessimistic in recessionary periods and too optimistic during booms. It has become widely accepted as a useful tool for valuing stocks.
The valuation of the U.S. stock market now stands at levels only seen twice before in recent history. Neither inspire confidence. Once was in the 1920s before the Great Depression and the other in 2000 before the .com bubble burst. Both were bad periods for stocks.
Barclays currently has the U.S. CAPE at almost 40 as of October 2021. In part this is due to high valuations and high weighting to technology stocks in the U.S. market. However, still, just under half of S&P 500 companies today have a PE over 20x. This is not a cheap U.S. market.
Is This Time Different?
The CAPE is not entirely predictive of markets. Looking ahead 5-10 years it may predict around a third of future returns. So it’s not definitive, and it’s not a short-term predictor. Nonetheless, as long term metrics go, it has a better record than many other forecasting methods.
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However, Robert Shiller himself argued in a recent paper that although the CAPE is indeed very high compared to history, bond yields are remarkably low (albeit potentially rising in 2022). Therefore, if you examine the excess CAPE yield over bonds, stocks may appear attractive, because bond yields are so low today compared to much of history. Though some disagree that stock and bond yields should be compared so simplistically.
What To Do?
If you are concerned about the high CAPE ratio then one option to consider is international diversification. This has generally helped smooth the returns of portfolios over history. Today while the U.S. market is relatively expensive, other markets are less so.
For example, investing in the markets of Japan, China and Europe appears to offer a more attractive valuation based on CAPE valuation. Also, if you think the U.S. is worth more because of its high concentration of tech stocks, remember that China has a large share of tech too.
However, history also reminds us of the risk of making shorter term calls based on the CAPE. For example the U.S. CAPE broke through the symbolic level of 30 in 1997, but the index did not then begin to fall until 3 years later. So the CAPE should give investors reason for caution, but equally the impact may not be immediate.