What the CAPE ratio signals about the U.S. stock market

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I’m just sitting on a fence
You can say I got no sense
Trying to make up my mind
Really is too horrifying
So I’m sitting on a fence — The Rolling Stones

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See more : Asian shares are mostly higher after Wall Street rally caps a dismal week

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Nobel Prize winner Robert Shiller popularized the cyclically adjusted price-to-earnings (CAPE) ratio. CAPE compares stock prices with earnings smoothed across multiple years, which provides a long-term perspective by dampening the effects of expansions and recessions.

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Clearly, having higher exposure to stocks when CAPE levels were low and lower exposure when CAPE levels were high would have resulted in both less severe losses in bear markets and higher returns over the long-term.

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Since 1881, the average of the 10 lowest year-end CAPE ratios for the S&P 500 Index is 7.0. Following these periods, the index had an average real return of 17 per cent over the subsequent year and an average annualized real return of 11.5 per cent over the next 10 years.

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In contrast, the average of the 10 highest year-end CAPE ratios is 31.9. Following these periods, the index had an average real return of 5.3 per cent over the subsequent year and an average annualized real return of 2.2 per cent over the next 10 years.

While it sometimes takes time for the proverbial party to get started when CAPE levels are depressed, markets performed admirably over the medium to long-term.

Although markets may perform well for a while when CAPE levels are elevated, eventually the valuation reaper exacts its toll on markets.

Guess where the CAPE ratio currently stands

Given the historically powerful relationship between starting CAPE levels and subsequent returns, what if I told you that the CAPE ratio currently stands in the 96th percentile of its range over the past 50 years? My guess is that you would consider taking a more cautious stand on U.S. stocks.

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See more : Asian shares are mostly higher after Wall Street rally caps a dismal week

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Now let’s pretend that you knew nothing about this relationship. Recency bias might give you a false sense of confidence that what has occurred in the recent past will continue in the future. Also, recent gains might exacerbate your FOMO (fear of missing out) and prompt you to increase your equity exposure. Lastly, new innovations such as artificial intelligence can incite euphoria to the point where you believe that there is no price that is too high to pay for the unlimited profit potential of the “shiny new toy.”

Standing at the crossroads

So here we stand at a crossroads, caught between the weight of history and the possibility that this time may be different.

Microsoft Corp. and Amazon.com Inc. have been very profitable long-term investments since the beginning of 2000. However, this didn’t prevent them from suffering severe losses over the next several years. By September 2001, Amazon stock had fallen by more than 90 per cent and did not recoup its losses until 2007. Microsoft plummeted 65 per cent by early 2009 and did not reach its January 2000 level until 2014.

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In comparison, the equal-weighted S&P 500 Index, which was far less exposed to the TMT (technology, media, and telecom) craze of the day, suffered a maximum decline of approximately 30 per cent and recouped its losses by October 2003.

In hindsight, the issue was valuations that were highly unrealistic. As was the case then and may very be the case today, there is such a thing as too high a price, even for great businesses.

When the S&P 500 Index began its largely uninterrupted run in March 2009, its CAPE ratio stood just above 13, as compared with its current level of 38, which coincidentally is where it was at the end of 2021 before markets turned ugly. Perhaps even more ominously, rates are far higher today than they were then. It will take something extraordinary for the S&P 500 to produce good returns over the next several years, and investing that requires something extraordinary to occur has historically been a bad idea, notwithstanding a small handful of exceptions.

Don’t throw the baby out with the bathwater

The current lofty valuation of the S&P 500 is inextricable from the megacap technology juggernaut that has dominated the U.S. stock market over the past decade. Outside of these highly valued behemoths, the U.S. market is not nearly as daunting from a valuation perspective.

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The equal-weighted S&P 500 Index has a far lower exposure to megacap growth stocks and, by extension, more of a value bias than its capitalization weighted counterpart. Importantly, its forward price-to-earnings (P/E) ratio currently stands at about 19.8, representing a 21.4 per cent discount to the capitalization weighted index’s approximately 24. Moreover, stocks in other countries lie at or below their historical average valuation levels.

Warren Buffett famously said, “Price is what you pay. Value is what you get.” Over periods of years and decades it is evident that returns are heavily dependent on the prices paid for assets. Relatedly, investors need not reduce their overall equity exposure but should be playing the odds by shifting their U.S. exposure in favour of value stocks and tilting their country exposure towards non-U.S. developed equities.

Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.

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See more : Asian shares are mostly higher after Wall Street rally caps a dismal week

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