Today is another article from the Fee-Only Financial Advisor Blog Sharing Group. This group is made up of other like-minded financial advisors from around the country. The purpose of the group is to share useful content and spread the word about the virtues of Fee-Only financial advice. The contributor of this article is Stephen Reh of Reh Wealth Advisors from California. His article looks at whether or not the stock market is overvalued. He uses a rarely heard of metric called the CAPE ratio. He'll explain what this is, how it works, and what it tells us about the current state of the stock market.

The Dow recently hit 20,000! This was a big psychological level for investors. While breaking this barrier is, in reality, insignificant, it symbolizes the continued growth of the stock market but also that the market may be getting too expensive. After all, the stock market has never been higher! But let’s look at the data to see how overvalued the market really is...

CAPE – Cyclical Adjusted Price Earnings Ratio - Shiller P/E – P/E 10 Ratio

First off, this is a valuation measure for the stock market which is based on another valuation measure, the price earnings ratio. So, what is the CAPE? It’s the Cyclically Adjusted Price Earnings ratio! I’ll bet your next question is “what’s that?”. In this article, I will break it into simple terms to help you understand better and apply it to today’s stock market.

Price Earnings Ratio

In order to understand the CAPE ratio we need to explain what a Price to Earnings Ratio is and how it works. The Price to Earnings Ratio of the market, or P/E ratio, is simply the price of the stock market divided by the earnings of the market. This can also be applied to individual stocks but in this context, think of the market as a whole. The higher the P/E ratio the more expensive the market is, i.e., you are paying more in price for a relative share of profits (earnings). There is trailing P/E (based on recent historical earnings) and forward P/E (based on projected earnings estimates) but for the scope of this article, just understand it’s the price divided by the earning. <See: More Information on P/E Ratio>

Valuation Ratio

Next we have to look at something called a valuation ratio. This is simply a ratio that attempts to tell you how “expensive” (overvalued) the stock market is relative to its history. We are going to use this by looking at the current P/E, we can compare to previous years P/E ratios. If its higher, than we would say values are “rich” or potentially overvalued. If its lower than average, the valuations are potentially undervalued. Are you getting curious about the current market valuation? Read on, we’re getting there.

So What Does Cyclically Adjusted Mean?

In the case of the CAPE, it’s the average of the last 10 years earnings adjusted by inflation. The point of the CAPE is to adjust for an entire stock market / business cycle. In most cases 10 years would capture a complete cycle. It’s really just a way to normalize the data.

What is the Intention of the CAPE Ratio?

The original intent was to forecast future long term returns and if they would be expected to be higher or lower than average. It is not intended to predict market crashes although by definition market corrections happen when markets are overvalued (otherwise they are not really overvalued are they?).

What is the Historical CAPE and Current CAPE?

The mean CAPE ratio is 16.72 since 1880. The current CAPE is 28.41 as of 02/06/2017. <Source: Shiller PE Multpl.com> That sounds like the market is dramatically overvalued. However, the world was drastically different in 1880. The period includes the Great Depression and two World Wars. Since 1990, however, CAPE has only spent 2% of it's time below its historical average. If it’s mean reverting, it should have reverted and returned near its mean. What does this tell us? It’s dangerous to use the measure to time the stock market. Looking at CAPE over the past 25 years reveals a much different story. According to JP Morgan’s guide to the market, the CAPE ratio has averaged 26. The current CAPE of 28.5 then feels very normal and that the market is not overvalued.

Further, Jeremy Seigel from Wharton Business School argues that the CAPE uses a measure that is not consistently defined. Earnings over time have been measured differently. You cannot compare earnings in 1920 vs earnings in 2017 because the earnings are measured differently. For example, companies used to have to write off Goodwill over time. Since 2001, they must test for impairment and only write-off good will if it was no longer worth what the company paid. It doesn’t matter if you know what Goodwill means, the point is the definition of earnings has changed which makes the CAPE ratio flawed.

S&P500 Index: Forward P/E Ratio - Source JP Morgan Guide to the Markets

Moral of the Story?

So what is today’s “moral of the story”? That I can use CAPE to argue the market is severely undervalued by comparing it to the late 1990's and that I can make it look severely overvalue by looking at periods of time prior to 1990. Why is this important to you the investor? It’s important to know that valuation ratios can give us a picture of the market but they can be manipulated by the person telling the story. Inevitably, I get asked which ratios do I use and why? I use the 25 year average because I think it’s more applicable to today’s world. I also use more than one valuation ratio to create a better picture of the market. Here is the spoiler alert, the vast majority of the time the picture painted is that the market is fairly valued. According to JP Morgan’s Guide to the Markets, three ratios (P/E, CAPE, and P/CF) show the market is slightly overvalued and 3 ratios (Dividend yield, P/B, and EY Spread) show that market is undervalued. How do I read into that? The market is fairly valued or at least reasonably close.

Is the Stock Market Overvalued? Take a look at CAPE to find out.