Mitch's Mailbox

February 24th, 2022

Are Stocks Too Expensive?

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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 planning a retirement strategy that takes the “what ifs” into account. Never give in to the fear of what’s to come. It’s better to prepare for it! Our free guide can help you to prepare as you strive for long-term success.

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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.

DISCLOSURE

Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.

Zacks Investment Management, Inc. is a wholly-owned subsidiary of Zacks Investment Research. Zacks Investment Management is an independent Registered Investment Advisory firm and acts as an investment manager for individuals and institutions. Zacks Investment Research is a provider of earnings data and other financial data to institutions and to individuals.

This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional legal, tax, or accounting counsel. Publication and distribution of this article is not intended to create, and the information contained herein does not constitute, an attorney-client relationship. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of herein and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole.

Any projections, targets, or estimates in this report are forward looking statements and are based on the firm’s research, analysis, and assumptions. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources may be required to make informed investment decisions based on your individual investment objectives and suitability specifications. All expressions of opinions are subject to change without notice. Clients should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed in this presentation.

Certain economic and market information contained herein has been obtained from published sources prepared by other parties. Zacks Investment Management does not assume any responsibility for the accuracy or completeness of such information. Further, no third party has assumed responsibility for independently verifying the information contained herein and accordingly no such persons make any representations with respect to the accuracy, completeness or reasonableness of the information provided herein. Unless otherwise indicated, market analysis and conclusions are based upon opinions or assumptions that Zacks Investment Management considers to be reasonable.

Any investment inherently involves a high degree of risk, beyond any specific risks discussed herein.

Returns for each strategy and the corresponding Morningstar Universe reflect the annualized returns for the periods indicated. The Morningstar Universes used for comparative analysis are constructed by Morningstar (median performance) and data is provided to Zacks by Zephyr Style Advisor. The percentile ranking for each Zacks Strategy is based on the gross comparison for Zacks Strategies vs. the indicated universe rounded up to the nearest whole percentile. Other managers included in universe by Morningstar may exhibit style drift when compared to Zacks Investment Management portfolio. Neither Zacks Investment Management nor Zacks Investment Research has any affiliation with Morningstar. Neither Zacks Investment Management nor Zacks Investment Research had any influence of the process Morningstar used to determine this ranking.

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