The past few years has seen a growing discussion around how to best value the market. More recently, the argument turned toward just how overvalued is the market and what does it mean? I thought I’d try to answer those two questions.
Several market valuation tools have become more common since the crisis. I use the term loosely because none of the valuation tools are 100% accurate and some are terribly inaccurate. In reality, people want a market timing tool. Keep that in mind while reading further.
One of the more popular tools is the CAPE ratio (Cyclically Adjusted PE Ratio) or Shiller PE named after it’s creator, Robert Shiller. Shiller is a Yale professor who realized the market is hardly efficient, wanted a way to measure that inefficiency, and wrote a book about it appropriately named Irrational Exuberance.
For anyone new to the CAPE ratio here is the short version. I’ve covered the PE ratio before. The CAPE ratio is similar. CAPE takes the S&P 500’s price and divides by the average earnings over the past 10 years. Using average earnings helps to limit big swings from one year to the next.
Shiller recently added his two cents to the valuation discussion via twitter:
My CAPE (cyclically adjusted price earnings) ratio reached 27.60 at close of market today, passing 2007 high. http://t.co/XbP0eZ2TA7
— Robert J Shiller (@RobertJShiller) February 13, 2015
Unfortunately, Shiller’s two cents don’t help answer the questions above. So I thought I’d look at where the CAPE ratio started previous years and show how the S&P 500 performed afterwards, which should put the current valuation into context.
CAPE Breakdown
The tables below break down the CAPE ratio based on where it stood on January 1 of each year from 1926 to 2015 with the following average S&P 500 performance (with dividends) over different time periods. CAPE data is from Multpl.com.
| S&P 500 Returns following CAPE below 10 | ||||
| 1 Year | 3 Years | 5 Years | 10 Years | |
| Average | 18.59% | 17.41% | 16.40% | 14.23% |
| Median | 20.00% | 16.47% | 15.05% | 15.10% |
| High | 53.99% | 30.87% | 22.47% | 17.59% |
| Low | -8.19% | 11.69% | 14.07% | 6.43% |
The CAPE ratio has started the year below 10 only ten times. The last time was 1984. The lowest January 1 CAPE was 7.39 in 1982.
| S&P 500 Returns following CAPE 10 to 15 | ||||
| 1 Year | 3 Years | 5 Years | 10 Years | |
| Average | 18.42% | 16.99% | 13.97% | 14.21% |
| Median | 19.27% | 17.31% | 14.40% | 14.63% |
| High | 52.62% | 30.14% | 23.92% | 20.06% |
| Low | -26.47% | 5.42% | -5.11% | 5.86% |
There were twenty-six periods were CAPE started the year between 10 and 15. The last time was in 1988.
| S&P 500 Returns following CAPE 15 to 20 | ||||
| 1 Year | 3 Years | 5 Years | 10 Years | |
| Average | 10.05% | 6.20% | 7.90% | 9.89% |
| Median | 9.79% | 7.01% | 9.39% | 9.17% |
| High | 43.61% | 18.52% | 17.94% | 19.21% |
| Low | -43.34% | -7.39% | -12.47% | 0.02% |
There were twenty-two periods where the CAPE began the year between 15 and 20. the last time was 2009.
| S&P 500 Returns following CAPE 20 to 25 | ||||
| 1 Year | 3 Years | 5 Years | 10 Years | |
| Average | 5.98% | 9.11% | 9.12% | 6.00% |
| Median | 11.76% | 8.65% | 7.97% | 6.32% |
| High | 37.58% | 31.15% | 28.56% | 12.07% |
| Low | -37.00% | -26.90% | -9.93% | -0.05% |
There were twenty periods where the CAPE started the year between 20 and 25. The last time was 2014. Side note – the Highs were all from 1995.
| S&P 500 Returns following CAPE over 25 | ||||
| 1 Year | 3 Years | 5 Years | 10 Years | |
| Average | 6.23% | 0.17% | 0.27% | 3.39% |
| Median | 5.49% | -1.03% | -0.25% | 2.92% |
| High | 33.36% | 27.56% | 10.70% | 8.42% |
| Low | -22.10% | -26.96% | -11.24% | -1.38% |
CAPE started the year above 25 only twelve times. The last time was 2015. The highest CAPE ratio was 43.77 in 2000. Side note – the Highs were all from 1997.
Summary
Let’s focus on generalities because the tables show CAPE isn’t perfect in predicting future returns. Instead, you’re dealing with a range of possible outcomes and what’s more likely to happen.
As a general rule, lower valued markets tend to outperform and higher valued markets tend to underperform due to mean reversion.
Nothing new there, except investing is full of general rules that get broken from time to time. While the rule is the most likely outcome, there are instances where it doesn’t happen.
The CAPE ratio, while imperfect, has a better use as a long term expected returns tool. Simply, CAPE is a poor predictor of short term returns.
Sorry to say, that eliminates it as a market timing tool too. You only have to look at the 1 year and 3 year Highs in the last table, both from 1997 to understand why. The three years starting in 1997 saw the peak of the internet bubble. Just because the market is overvalued doesn’t mean it can’t get more overvalued. In other words, the markets can stay irrational despite high valuations.
I won’t get into the debate of CAPE’s usefulness. It’s an imperfect tool, like all the rest, with one big shortfall.
The historical CAPE average has been creeping higher for any number of reasons – changes in accounting rules, tax code, profit margins, and the make up of the S&P 500 – which may or may not be permanent. This is most obvious when you compare the historical average with the average over the past twenty-five years:
- 1881 to 2015 – 16.58
- 1926 to 2015 – 17.65
- 1990 to 2015 – 25.30
You don’t need to be a genius, or a Yale professor, to see something has changed. You do need to understand that valuation alone isn’t a guarantee that a low market will rise or a high market will fall anytime soon. As the tables show, the market doesn’t always follow the rules. You’ll have to decide CAPE’s usefulness for yourself.
