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CAPE says the markets are expensive – but should you listen?

A deep(ish) dive into the meaning and utility of Robert Shiller's cyclically adjusted price to earnings ratio

When he was younger, Max Fawcett wanted to make a mint in the markets. Now as the managing editor of Alberta Venture he gets to write about them. Close enough, right? He can be reached at mfawcett@albertaventure.com

Jan 15, 2014

by Max Fawcett

With stock indices continuing to press upward more than 28 months since the last meaningful correction, it’s not hard to find pundits who are arguing that the markets are dangerously overvalued. And one of the most common pieces of evidence they introduce in support of their position is the cyclically adjusted price to earnings ratio, or CAPE, a metric popularized by Yale economist Robert Shiller. As Business Insider’s Sam Ro explains, “CAPE is calculated by taking the S&P 500 and dividing it by the average of 10 years’ worth of earnings. If the ratio is above the long-term average of around 16-times, the stock market is considered expensive. Currently, the CAPE is at 24.42-times, which has some people freaked out.” And that was back in early November, before the market tacked on more gains.

But over at The Reformed Broker, Joshua Brown suggests that the CAPE – at least, as some people are using it – isn’t the end-all, be-all when it comes to determining appropriate market valuation. “Consider that the US stock market has spent more than 95 per cent of the last quarter of a century above the level that CAPE would say is expensive relative to long-term historical valuations,” he wrote in a recent post. “In that time, the S&P has increased by more than 450 per cent, from 330 in 1990 to over 1,840 today. To say that a total market increase of this magnitude, and over this length of time, all occurred within the context of what one would term a historically ‘overvalued’ condition simply means that this tool’s definition of ‘overvalued’ is, in and of itself, incorrect.”

It’s not that CAPE should be ignored, he says. But those who use it to try and time the market have already learned the hard way that it’s not particularly helpful in that respect. “My argument is not that the CAPE Ratio is useless – in fact, quite the opposite; it is among the best measures of long-term valuation mankind has yet devised for the complex adaptive system that is the stock market. Unfortunately, it is just that – a long-term and laggard measure of valuation, one of many, that doesn’t even come close to explaining what might come next. From a timing standpoint, it is not merely useless, but dangerously so. Adherents of CAPE were telling anyone who would listen that U.S. equities were as much as 40 per cent overvalued as of July 2009, some 8,000 thousand Dow Jones points ago.”

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