Snapshot - Economics
Is this popular measure of stock market value giving a misleading “sell” signal?
Here's why scare stories about the current CAPE being a predictor of doom may prove to be wide of the mark.
10 January 2019
One of the most widely watched measures of stock market value, the cyclically-adjusted price to earnings ratio (CAPE), has been giving off a screaming “sell” signal for the US market in the past few years.
Last year it rose to a level not seen in its almost 140 year history, other than during the peak of dotcom hysteria. Market watchers everywhere have pointed to this as a warning sign that future returns are likely to be depressed.
However, the past few months’ market declines have already brought it back from the abyss. Just as importantly, its calculation is being distorted by the lingering effects of the financial crisis so it is giving a misleading signal. Once you account for this, the US no longer looks so expensive after all.
CAPE compares the stock market level with average earnings over the previous ten years, all in inflation-adjusted terms. The lower the figure, the better the value (although investors would be wise to consider a wider range of valuation indicators than this alone as they all have their pros and cons and often give conflicting signals – read how to value stock markets for more information).
The rock-bottom time for earnings was 2009, during the financial crisis, and its inclusion in the ten-year average drags down the figure considerably. This makes current prices look high relative to ten-year average earnings. The financial crisis was the worst recession since the Great Depression so, unless you think a repeat is on the cards, it is not particularly meaningful to use it as a guide to some estimate of normalised earnings.
However, by the end of 2019, 2009 will fall out of the CAPE calculation period. Even if we assume that earnings and prices are unchanged in inflation-adjusted terms over 2019, the US CAPE will fall further to a level of 24 by year end. This would be significantly below the level of 33 it reached in 2018 and slightly below the median of the past 15 years.
It would even be approaching the median based on data covering the past half century. It is far from being a screaming buy on this measure but scare stories about the current CAPE being a predictor of doom may prove to be wide of the mark.
Important Information: This communication is marketing material. The views and opinions contained herein are those of the author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. It is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a reliable indicator of future results. The value of an investment can go down as well as up and is not guaranteed. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Schroders has to its customers under any regulatory system. Regions/ sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this material include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. To the extent that you are in North America, this content is issued by Schroder Investment Management North America Inc., an indirect wholly owned subsidiary of Schroders plc and SEC registered adviser providing asset management products and services to clients in the US and Canada. For all other users, this content is issued by Schroder Investment Management Limited, 1 London Wall Place, London EC2Y 5AU. Registered No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.