When pricing stocks, I like to use the CAPE, not the P/E ratio. If you’re unfamiliar with CAPE it is the cyclically adjusted price-to-earnings ratio.
In simple terms CAPE measures the price of stocks against the average of ten years’ worth of earnings, adjusted for inflation.
The reason you use the average earnings over 10 years is due to the business cycle. Typically the US experiences a boom and bust once every ten years or so.
By using the average earnings over a ten-year period, you smooth out your earnings data to account for both booms and busts. As a result you get a much clearer measure of a business’s profits which is the best means of valuing that business’s worth.
Today the S&P 500 has a CAPE of over 22 (see figure 2 on the next page). This means the market as a whole is trading at 22 times its average earnings of the last ten years.
Put another way, if you bought the entire stock market today, it would take you roughly 22 years to make your money back.
That is hardly what I’d call cheap.
To show you what I mean, I made a second graph depicting when stocks are cheap (CAPE below 15) and when they’re bubbly (CAPE above 20) in the figure below.
Anytime stocks get above a CAPE of 20, things are bubbly. Anytime they’re below 15, they’re cheap. And if they ever trade at a CAPE in the single digits, it’s an extraordinary time to buy.
Source: http://www.econ.yale.edu/~shiller/data.htm [2]
As you can see, with the S&P 500 at a CAPE of 22, stocks have only been this expensive a handful of times in the last 150 years.
All of these times occurred close to market peaks.
Today is no different. The market is at all-time highs, while corporate revenues are falling, and the US economy is sliding back into recessionary territory.
These are NOT the times to be heavily invested in stocks for the long run. CAPE has been proven by multiple research studies to be the single best predictor of stock returns in the long run, accounting for 43% of future price variation.
CAPE is better at predicting stock market returns than P/E, Government Debt/ GDP, Dividend yield, Fed Model, and many other metrics commonly used by analysts (most of which really predict much of anything).
This is not to say that stocks can’t go even higher than they are today. Bubbles, such as the one we’re experiencing today, can often last longer than anyone expects.
However, based on over 100 years’ worth of data, anyone who is looking to invest for the long term by buying the market today can expect, at best, a 4% real return per year over the next 20 years (this includes both dividends and capital appreciation after inflation).
Stocks are overpriced, overbought (margin debt is near record levels) and overvalued. This is not a good combination for any investor betting on the longside.
Investors take note, now is the time to be preparing for a market correction.
For insights on how to prepare for one visit us at:
http://gainspainscapital.com/protect-your-portfolio/ [3]
Best Regards
Graham Summers