Justin G. from Newark, N.J. asks: Hello Mitch, I was
thinking of investing some cash in the stock market with this latest pullback,
but I noticed that the CAPE ratio for measuring valuations is currently above
30x. It feels like stocks are still way too expensive! What are your thoughts?
Mitch’s Response:
Thanks for
writing, Justin. Let me first clarify a point for readers who may not be
familiar with the CAPE ratio. This ratio is a valuation tool that takes the
price of the S&P 500 index and divides it by the average of the previous 10
years of earnings, adjusted for inflation.
I think there are
a couple of key flaws with the CAPE ratio. For one, it is always looking at
historical earnings, making it a backward-looking metric. The stock market does
not care about where earnings have been, but rather where they are going.1
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The second issue I
see is that the CAPE ratio has not been a meaningful forecasting tool for
whether the stock market is about to do well or poorly. Here is a glaring
example of what I mean: back at the beginning of 2010, the CAPE ratio was at
20.3x – putting it well above the historical average of 16.3x dating back to
1881. Many prognosticators used the high CAPE ratio to predict a decade of weak
returns for the S&P 500.
The opposite
happened.
Over the 10 years
ending December 31, 2019, the S&P 500 delivered an annualized return of +13.6% – well above the long-term
average for the index. Any investor who used a high CAPE ratio in 2010 as a
thesis to underweight stocks for the medium term likely felt an adverse impact on
returns.
Even though the
CAPE ratio was signaling a challenging road ahead in 2010, the stock market
boomed. Why? Because earnings boomed. In short, the CAPE ratio does not offer
investors any insight as to what’s ahead for earnings. The ratio itself is
incapable of telling us anything about what sectors are poised for growth, what
industries are poised to thrive, and what innovations could drive new profit
growth and fundamentally change the way the economy works. And at the end of
the day, that’s what the stock market moves on.
You are correct to
point out that the CAPE ratio is currently above 30x, and by my last check is
even above 35x. That’s higher than the ratio was in September 1929 (32.6x)
before the Depression, but not as high as the record set in December 1999
(44.2x). But what does that high CAPE ratio tell us? If the market is currently
trading at high levels relative to historical earnings, but then earnings soar
in the years ahead, does it matter?
In my view, the
key fundamental to monitor is where earnings are expected to go in the next
twelve months, and how the market is currently priced relative to those future
earnings – not past ones.
The future of the market is unpredictable – and that’s why I
recommend that investors, especially those who are nearing retirement, start
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Disclosure
1 Wall Street Journal. February 11, 2022. https://www.wsj.com/articles/the-trouble-with-a-stock-market-bubble-11644595216
2 ZIM may amend or rescind the guide “How Solid Is Your Retirement Strategy?” for any reason and at ZIM’s discretion.
3 ZIM may amend or rescind the guide “How Solid Is Your Retirement Strategy?” for any reason and at ZIM’s discretion.
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