CAPE Ratio Pointing to a Downturn?

May 2, 2014   //   by Profitly   //   Market, Profitly, Risks  //  Comments Off on CAPE Ratio Pointing to a Downturn?

With the Dow and the S&P near record highs and people talking about a bubble in the tech and biotech sectors, a lot of people are studying up on different valuations so they can catch the next big trade and trade the best stocks, whether long or short. The Dow’s recent record closing high of 16580 on Tuesday and intraday record of 16631 on April 4 along with the S&P 500’s record closing high of 1890 on April 2 and intraday record high of 1897.28 on April 4 have everyone buzzing about stocks trying to find the best stocks out there.

One of the valuations metrics that people have been looking at lately is something called the “CAPE ratio,” also known as the “P/E 10 Ratio” or “Shiller PE ratio.”

So what exactly is it and how can it help you learn how to trade the best stocks and find the best stocks to invest in? Let’s start with this a great definition by Investopedia:

“It’s a valuation measure, generally applied to broad equity indices, that uses real per-share earnings over a 10-year period. The P/E 10 ratio uses smoothed real earnings to eliminate the fluctuations in net income caused by variations in profit margins over a typical business cycle. The ratio was popularized by Yale University professor Robert Shiller, who won the Nobel Prize in Economic Sciences in 2013. It attracted a great deal of attention after Shiller warned that the frenetic U.S. stock market rally of the late-1990s would turn out to be a bubble. The P/E 10 ratio is also known as the “cyclically adjusted PE (CAPE) ratio” or “Shiller PE ratio.”

The P/E 10 ratio is calculated as follows – take the annual EPS of an equity index such as the S&P 500 for the past 10 years. Adjust these earnings for inflation using the CPI. Take the average of these real EPS figures over the 10-year period. Divide the current level of the S&P 500 by the 10-year average EPS number to get the P/E 10 ratio or CAPE ratio.

A criticism of the P/E 10 ratio is that it is not always accurate in signaling market tops or bottoms. For example, an article in the September 2011 issue of the “American Association of Individual Investors’ Journal” noted that the CAPE ratio for the S&P 500 was 23.35 in July 2011. Comparing this ratio to the long-term CAPE average of 16.41 would suggest that the index was more than 40% overvalued at that point. The article suggested that the CAPE ratio provided an overly bearish view of the market, since conventional valuation measures like the P/E showed the S&P 500 trading at a multiple of 16.17 (based on reported earnings) or 14.84 (based on operating earnings). Although the S&P 500 did plunge 16% during a one-month span from mid-July to mid-August 2011, the index subsequently rose more than 35% from July 2011 to new highs by November 2013.”

One prominent individual that has been taking a close look at valuation measures, including the CAPE ratio, is Henry Blodget, editor-in-chief of Business Insider. In a recent post, he said “Every valid valuation measure I look at suggests that stocks are at least 40 percent overvalued,” adding that he wouldn’t be surprised if we saw a crash soon. He thinks that just investing in stocks is likely to deliver crummy returns for the next seven years (or so). Not only does that mean that give you more reason to learn from people like the gurus on Profitly that trade rather than invest, it means that the average person in the stock market isn’t going to do very well for the next several years. His points and reasons for coming to this conclusion? He lays out the bullish and bearish cases:

  • Every valid valuation measure I look at suggests that stocks are at least 40% overvalued.
  • Corporate profit margins are at record levels and look like they might finally be rolling over.
  • Lots of sentiment indicators are flashing warning signs (folks are just way too bullish).

And what are the arguments that these concerns are silly and that stocks will keep rising?

  • One of the big bullish arguments seems to be that “there’s no catalyst” for a crash or bear market.
  • Another bullish argument is that the economy’s getting better.
  • Lastly, there’s a general sense that the financial crisis is finally over and that everything finally feels fine.

So which valuation measures suggest the stock market is very overvalued?

  • Cyclically adjusted price-earnings ratio (current P/E is 25X vs. 15X average — higher than any time in the past century with the exception of 1999-2000 and, very briefly, in 1929).
  • Market cap to revenue (current ratio of 1.6 vs. 1.0 average).
  • Market cap to GDP (double the pre-1990s norm).

Here is a recent chart of the CAPE ratio from Bill Hester of the Hussman Funds.

shiller-cape-1

The blue line shows the prediction for 10-year returns. The red line shows the actual returns. If you have heard people say, “CAPE doesn’t work anymore,” you might want to read Bill Hester’s analysis. He looks at all the arguments why CAPE doesn’t work and concludes that it does. (We’ll know for sure in 10 years.)

Second, in case you have been convinced that the “CAPE” ratio no longer works, here’s a look at price-to-revenue.

screen shot 2013-12-24 at 8.58.26 am

This measure is calling for a slightly better long-term return for the S&P 500 — just under 5% — but still a far cry from the long-term average. And far less than the guru’s and their students make in a year. Can you see why looking at charts like this will help you better understand technical patterns and other charts that the gurus look at? You have to know about stuff like this if you want to be a successful trader. Profitly gives you the tools and resources to learn from the best.