SHILLER CAPE RATIO 2ND HIGHEST LEVEL IN HISTORY
Shiller CAPE - The Stock Market is at it’s 2nd Highest Valuation in History
The stock market’s valuation is slightly higher than it was in 1929, higher than it was in 2008, and is second only to the high valuation achieved in 1999; as measured by the Shiller Cyclically Adjusted Price Earnings ratio (known as the CAPE). Chart and details below.
Source: https://www.multpl.com/shiller-pe
So who cares? Warren Buffett cares, as a value investor who pays attention to managing risk by avoiding over paying for an investment. In fact, his mentor Ben Graham (the Father of Value Investing) was a disciple of the Dow Theory. In a 2017 interview with CNBC Warren Buffett credited three people with his success; his father, his wife, and his mentor Benjamin Graham.
https://www.cnbc.com/2017/09/29/warren-buffett-credits-his-success-to-these-3-people.html
The Dow Theory is core to value investing, still in use today by thousands of investors.
Warren Buffett is the Chairman of Berkshire Hathaway. He has an uncanny knack for having a lot of cash on hand when valuations are high and things start to happen. By the way, Berkshire Hathaway has a record amount of cash on hand.
Source: www.ycharts.com
The CAPE was developed by Robert Shiller, a Nobel Prize winning economist at Yale. He popularized the metric during the Dotcom Bubble when he argued (correctly) that equities were highly overvalued. For that reason, it’s also casually referred to as the “Shiller PE”, meaning the Shiller variant of the typical price-to-earnings (PE) ratio of stocks.
http://www.econ.yale.edu/~shiller/
The level of the Shiller CAPE ratio is inversely related to future expected returns for the S&P 500. A low value indicates that stocks are priced at a low or reasonable valuation, when that happens Shiller calculates that the subsequent returns for the S&P 500 are above average. Likewise, when the Shiller CAPE has a high value the subsequent returns for the S&P 500 are low and can include large drawdowns.
Professor Shiller desired to improve upon the ‘regular PE Ratio’ by incorporating the effects of inflation, reducing fluctuations caused by the variation of profit margins throughout the business cycle, and the short term capabilities of CFOs to manipulate earnings. The result was a ratio that divides average earnings over the latest business cycle rather than just one recent year of bad or good earnings.
Why is the regular PE Ratio deceiving? The regular PE Ratio is calculated using the trailing 12 months of S&P 500 earnings. During economic expansions, companies have high profit margins and earnings. The PE Ratio then looks artificially low due to higher earnings. During recessions, profit margins are low and earnings are low. The ratio then looks artificially higher.
An example, the highest peak for the regular PE was 123 in the first quarter of 2009 (the S&P 500 had just crashed 50% from its’ high in 2007). The regular PE Ratio was high because earnings were depressed. People should have been buying, but the regular PE Ratio said the market was too highly valued. On the other hand, the Shiller CAPE was at 13.3, its lowest level in decades, correctly indicating a better time to buy stocks.
Today the Shiller CAPE ratio is signaling over valuation, at a historic level. In my opinion it makes sense that investors prepare their portfolios for scenarios similar to 1929 and 1999, to me this is rational given that today’s Shiller CAPE ratio valuation is equivalent to those two periods.
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