It’s nearly impossible to pinpoint market tops or bottoms with accuracy and precision. But monitoring the market’s movements into overvalued or undervalued territory can be done with much greater consistency and reliability.
The reason for this is that market valuations tend to move slowly. And unless you are using the right tools, that is, indicators designed to measure conditions looking forward, it’s easy to allow over/undervalued market levels to slip right past us.
Introducing the CAPE Shiller PE Ratio
The cyclically adjusted price-to-earnings ratio, known as the CAPE Shiller P/E ratio is a valuation measure applied to the S&P 500 that uses real earnings per share, adjusted for inflation, over a 10-year period. The ratio was popularized by Yale University professor Robert Shiller.
If you’re not familiar with what a PE ratio is, here’s a quick explanation. A price-to-earnings (PE) ratio is calculated as Market Value per Share / Earnings per Share. So if a stock has a PE of 20, then that means investors are willing to pay $20 for every $1 of earnings per share. As a side note, the PE ratio is also referred to as a price multiple.
Earnings are reported on a quarterly basis. This means that earnings do not change very frequently. But stock prices which are more volatile can sometimes rise and fall significantly on a daily basis. So by dividing market value by earnings, you can see if PE is multiplying or contracting.
When PE ratios reach extreme levels, it often signals that a stock may be significantly overvalued or undervalued.
What the CAPE Shiller PE Ratio Means for Return Expectations
Positive returns: Shiller had noted that historically, if a multiple is below 10, then the likelihood of a positive return is strongly in your favor. After all, a multiple needs room to expand (room for people to bid price upwards), and since a bull market often involves PE expansion, then you can expect price multiples to grow, as investors are willing to pay higher prices for shares. Based on Shiller’s research, a PE reading of 10 may be considered undervalued and favorable for purchase (given strong fundamentals).
Negative returns: Shiller also noted that the higher the PE gets, the lower the potential return. And if PE is over 20, then there’s a possibility that you may get negative returns, as such levels may be highly overvalued. This means that investors have bid-up prices to a point far beyond its current earnings may justify. Hence, the PE may likely “contract,” rather than expand; prices are more likely to fall or “correct.”
Our Current Market Levels: Highly Overvalued
If the Shiller PE ratio historical reading remains accurate, expect to make negative returns in this market as current valuations are excessively overvalued at the current reading of 32.89.
This reading is nearly double the historical mean of 16.56.
It’s worth noting that our current levels are higher than the periods leading up to:
- The 2008 financial crisis;
- 1987 Black Monday; and
- 1929 Black Tuesday.
The only instance to surpass our current PE is the tech boom of 2000.
The market cycle will inevitably revert to mean and cycle back toward undervalued levels. Until then, it might be wise to anticipate a massive PE contraction, one that may provide a lengthy period of negative returns.
In other words, it may be time to hedge your position by purchasing an undervalued safe haven asset such as gold and silver while lightening your load in equities.