Sidestepping Frothy Markets

1/9/2017


From tulip bulbs to Beanie Babies, myriad fads have mutated into investment crazes that eventually share the same sad ending.

While many of those fads are genuine surprises, the sad ending they share is not.

Smart investors use valuation metrics to help protect themselves from getting swept up in the madness of crowds. One of the most popular is the trailing P/E ratio, which compares a stock's price to the past 12 months of earnings per share.

The trailing P/E can be misleading, particularly for cyclical companies, which often deliver peak earnings right before a sharp downturn.

The P/E can also send out false signals for the broad market. In times of unusually strong earnings, the ratio can make stocks look unrealistically cheap. And when profits are weakened by severe recessions, stocks will appear unduly expensive.

Seeking to smooth out these extremes, economists Robert Shiller and John Campbell developed the "cyclically adjusted price-earnings" or CAPE ratio. It values stocks relative to 10 years of earnings rather than just one year. Rarely have U.S. stocks looked so expensive based on the CAPE ratio. S&P 500 Index stocks currently average a CAPE ratio of 28.1, above their 20-year norm of 27.0 and 50-year norm of 19.8. U.S. stocks have traded at a higher level in just 67 months (4% of the time) since 1881, with only two spikes above that level: the Great Depression, and the technology bubble.

While stocks certainly appear pricier than usual, the CAPE ratio may overstate the situation. To compensate for changes to generally accepted accounting principles (GAAP) that have made it difficult to compare historical data, we calculated an alternative to the CAPE ratio. Our CAPE alternative divides the total value of U.S. stocks by the 10-year average for total U.S. after-tax corporate profits. Both statistics are compiled quarterly, by the Federal Reserve and U.S. Bureau of Economic Analysis, respectively.

Relative to the last 50 years of history, valuations look high, but not extremely so, based on our alternative to the CAPE ratio. The traditional trailing P/E ratio for the S&P 500 Index is currently well above its 50-year average but roughly in line with its 20-year norm.

A historical perspective for current stock valuations
Rarely have U.S. stocks looked so expensive based on the Shiller CAPE ratio. Stock valuations also look high, though not extremely so, based on our alternative to the CAPE ratio and the average trailing P/E ratio for S&P 500 stocks. Data goes back to 1881 for the CAPE ratio, and back to the fourth quarter of 1961 for our CAPE alternative ratio.
Time Period
CAPE
CAPE
Alternative
Ratio
S&P 500
Average
Trailing
P/E Ratio
Current
28.1
25.3
26.0
10-year average
22.9
23.8
25.8
20-year average
27.0
29.0
26.2
50-year average
19.8
21.5
19.0
100-year average
16.9
16.2
For last 50 years
% of periods greater than current 
11
29
13
Number of periods greater than current 
64
57
76
Total periods
600 *
200 **
600 *
* Months.     ** Quarters.

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