Case for Higher CAPE

One of the few concrete metrics the bears, the few that are left, have been pointing to current valuations as becoming excessive and will eventually necessitate a stock market correction.

The current standard market multiple on the S&P 500 Index is 18.5x expected full year 2017 earnings. This is both towards the high end of the historical average and should be considered a bit rich if earnings growth remains in the mid-single digits and we are in a rising rate environment.

But bears are really hanging their hats on another valuation measure; namely CAPE or the cyclically adjusted price-to-earnings ratio, which is a defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation.

You can find a good explanation and current readup of CAPE here.

This measure has been rising for years and the current CAPE now stands at 28.5, almost as high as the bubble days. The question is whether certain underlying fundamental changes in the stock market, such as more technology and service based companies with higher margins than heavy manufacturing, help explain and therefore justify the higher level.

Michael Batnick, otherwise known as the Irrelevant Investor, recently laid out case for a higher CAPE. Read an excerpt of the article below:

“Strange things happened near the boundaries”- James Gleick

Stocks are not cheap. The CAPE ratio is 28.46, above the long-term average of 16.73 and more expensive than 96% of all readings. But exactly how expensive are they, and what might this mean for future returns?

The chart below from Star Capital shows that the more expensive stocks are, the deeper the average drawdown. Also note that terrible losses are not limited to expensive markets; Cheap can get significantly cheaper.

Whether you choose the CAPE ratio or a different valuation metric, they all say the same thing; Expensive markets leave investors with a smaller margin for error. The more you pay, the less you get. The table below shows this relationship quite nicely

Data for the CAPE ratio in the United States goes back to 1881. But the CAPE ratio wasn’t even thought of until 1934 (Ben Graham), and it certainly didn’t go mainstream until just recently. Ben Carlson said “The fact that we now have data that wasn’t available in the past changes the nature of that past data.” This is such a great point. Today we know that the average CAPE ratio going back to 1881 was 16, but that long-term average isn’t static, it changes over time as new information enters the data series.

The chart below shows how the average CAPE ratio changes over time and you can see that it has been rising for the last 30 years, which I’ll get into in just a minute.

Jumping in or out of stocks based on valuation can be extremely difficult, if not completely impossible. The chart below plots the current CAPE ratio against its long-term average (at the time). It was last below it for a brief moment in 2008 and before that, you had to go back to 1988!

The CAPE ratio, among other valuation metric is high, but allow me to give a few possible explanations for why valuations have been drifting higher for the last thirty years. I can already hear the eyeballs rolling, “oh, I guess this time is different.” Hold on, I am not suggesting that valuations and stocks can’t get cut in half. I am also not suggesting that this will continue indefinitely, I’m just trying to bring some balance to the “stocks are expensive, sell everything” crowd. Also, I will feel no shame if this post marks the top. Alright, here we go.

Continue Reading at The Irrelevant Investor

— The Option Specialist

You May Also Like

About the Author: The Option Specialist