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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.

10.01.2019

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.

A snapshot of US CAPE

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.