What is the Cyclically Adjusted Price-Earnings Ratio Telling Us About Stock Market Valuations?

In this, my last posting of 2016, I want to examine the story of the year, the rather miraculous performance of the U.S. stock market, particularly since Donald Trump's surprise win in November.  

Here is a chart showing the one year performance of the Dow Jones Industrial Average:

During the first two months of 2016, Dow fell from its 2016 opening level of 17,405 to a low of 15,460 on February 11.  It rose to its 2016 high (and all-time high) of 19,987 on December 20, an increase of 14.8 percent from its 2016 opening level.  It has retreated to its closing level of 19,762 on December 30, however, the index still shows a year-over-year gain of 13.5 percent.  Since corporate earnings are a key part of stock growth, by way of comparison, here is what happened to growth in after-tax corporate profits on a year-over-year basis since the beginning of the Great Recession:  

Profits in the third quarter of 2016 grew by 4.3 percent on a year-over-year basis, the strongest growth rate since the third quarter of 2014.

Since I haven't visited Robert Schiller's CAPE or Cyclically Adjusted Price-Earnings Ratio also known as the P/E 10 Ratio since August, I thought it was time to take another look at what this indicator suggests about the current level of the stock market.  The CAPE Ratio is defined as follows:

"...the price of stocks (or the stock market as a whole) divided by the moving average of ten years of earnings adjusted for inflation."

Higher than average CAPE Ratios suggest that there will be lower than average long-term annual returns and lower than average CAPE Ratios suggest that there will be higher than average long-term annual returns on stocks.

Here is a line graph showing how the CAPE Ratio has varied on a monthly basis since 1881:

There are 1631 data points in Dr. Schiller's analysis which provide us with an average CAPE Ratio of 16.63 over the 135 year period keeping in mind that this includes the extremely anomalous CAPE Ratios that resulted from the tech sector bubble in the early 2000s.

Let's focus on the period of time since the Great Recession began at the end of 2007:

As you can see, the CAPE Ratio fell to a low of 13.32 in March 2009, the lowest level since March 1986 when the CAPE Ratio stood at 13.19.  Over the past six and three-quarters years, the CAPE Ratio has risen to its current level of 28.26 in mid-December 2016, an increase of 112.2 percent.  That said, the current CAPE Ratio is very high compared to the long-term average, in fact, at 28.26, it is 69.9 percent above its 135 year average as noted above.  

The current level of the CAPE Ratio suggests that the stock market is significantly overvalued, unfortunately, the CAPE Ratio does not telegraph when the stock market will return to normal valuations.  My suspicion is that the flight out of the bond markets have led investors into equities and that only time will tell when sanity returns and market valuations better reflect the reality of stagnant profit growth. 

What is the CAPE Ratio Telling Us About The Stock Market?

Updated October 13, 2015

The recent correction/downturn in the stock market seems to have taken many investors, both big and small, by surprise.  If one looks at historical stock market valuations, particularly price-to-earnings data, it is quite clear that the recent volatility to the downside should have been anticipated.

Robert Shiller, famed for his housing market index, has also accumulated a very large database of monthly price-to-earnings ratios for the stock market going all the way back to January 1871.   This data set includes monthly stock prices, dividends and earnings data along with the consumer price index (CPI-U) that allows the data to be converted to real/inflation-corrected values.  Stock price data are monthly averages of closing prices.  From this data, Dr. Shiller calculates the CAPE or Cyclically Adjusted Price-Earnings ratio which is also known as the P/E 10 ratio.  The CAPE ratio is defined as the price of stocks (or the stock market as a whole) divided by the moving average of ten years of earnings adjusted for inflation.  Higher than average CAPE values suggest that there will be lower than average long-term annual returns and lower than average CAPE values suggest that there will be higher than average long-term annual returns on stocks.  If you are interested, you can find Dr. Shiller's dataset here by clicking on the U.S. Stock Markets 1871 - Present and CAPE ratio.  If you wish to see the individual CAPE value for any given stock, please click here.

Now, let's look at a graph that shows the CAPE value from 1881 to the present:

We can quite clearly see how volatile the CAPE ratio has been over the fourteen decades and can see how it peaked and and dropped prior to and during the Great Depression, during the tech sector boom and bust of the late 1990s and early 2000s and how the CAPE ratio dropped during the Great Recession.  Over the past 134 years, the CAPE ratio has averaged 16.65 and has fallen in a range of between 4.78 in December 1920 and a peak of 44.2 in December 1999.  According to Dr. Shiller's calculations, on October 2, 2015, the CAPE ratio was 24.78.  According to this website, on October 13, 2015, the CAPE ratio was 25.49.  These values tell us that the stock market is still significantly overpriced compared to the 134 year average of 16.65 and that the recent correction should have come as no surprise to investors.  In fact, at either 24.78 or 25.49, the present CAPE ratio is still in the top 10 percent of all valuations over nearly a century and a half.

Here is a graph showing what has happened to the CAPE ratio since the beginning of the Great Depression in December 2007:

Over the 93 months, the CAPE ratio has averaged 25.34 and has fallen in a range of between 13.32 in March 2009 and a peak of 26.99 in February 2015.  

I can recall during the tech sector boom that many analysts suggested that the concept of price-to-earnings was no longer applicable to stock valuations, particularly since many tech sector companies had almost no earnings and extremely high valuations.  As we learned rather painfully, this was not the case and Dr. Shiller's analysis proved to be correct in the long-run.  At this point in time, it appears that the American stock market is still significantly over-priced when one compares present earnings to share prices to the levels experienced over the past century and that we should expect further volatility to the downside in the future.

The Price-Earnings Ratio and the Overbought Stock Market

Updated February 17, 2015

The recent volatility in the stock market has come as shock to many investors, however, looking at historical data, we shouldn't really be all that surprised.

Back in 2000, Yale Professor Robert Shiller, co-creator of the widely quoted Case-Shiller U.S. Home Price Index, wrote a book called Irrational Exuberance.  In the book, he used a data set consisting of monthly stock prices, dividends and earnings to ascertain whether or not the stock market is overvalued compared to historical levels.  The data which goes back all the way to 1874  and which is available here, is used to calculate the Cyclically Adjusted Price Earnings Ratio (CAPE or PE 10 Ratio).  There are currently just over 1720 data points in the set.  Dr. Shiller uses monthly dividend and earnings data that are computed from the S&P four-quarter totals for each quarter since 1926 which are then linearly extrapolated to month figures.  Stock price data is the monthly average of closing prices.  CAPE is defined as the stock price divided by the moving average of ten years of earnings corrected for inflation using the Consumer Price Index.  Higher than average CAPE values have a tendency to mean that average long-term annual returns will be lower and lower than average CAPE values have a tendency to mean that average long-term annual returns will be lower than average.

Here is a graph showing the entirety of the dataset:

Since 1881, the CAPE ratio has averaged 16.57.  On January 13, 2015, the CAPE ratio stood at 27.60, 66.6 percent above the cyclically adjusted 133 year average.  The bump in 2000 is a result of the technology stock frenzy when traditional valuations went out the door in the "new electronic economy".  We all know how that story ended, don't we?

Let's take a closer look at the CAPE ratio in the "modern era" from 1970 to the present (and yes, I know that I'm randomly picking a year):

Over the 45 year timeframe, the average CAPE ratio was 19.48.  The current CAPE ratio of 27.60 is still 41.7 percent above the cyclically adjusted 45 year average CAPE.

A brief look at Dr. Shiller's Cyclically Adjusted Price Earnings Ratio data would certainly suggest that the September 2014 stock market was overbought when compared to historical levels.  With this in mind, the current correction should not have been a shock to investors who were piling into the stock market in a rabid search for a decent return on their savings, thanks in large part to Mr. Bernanke and Ms. Yellen and their unshakeable belief in their zero interest rate policy.