Nothing can stop this bull market.
The Dow Jones has surged 900 points since early October and reached new highs Thursday, while the Standard & Poor’s 500 index pierced 1,800 for the first time ever. IPOs are hot again. Small investors, stirred from their post-recession daze, are coming back to stocks. And it’s been more than two years since the market has had a significant slump.
Those trends have raised concerns of a stock bubble.
But American economist Robert Shiller, winner of the 2013 Nobel Prize in economic sciences for his widely renowned research into market prices and asset bubbles, isn’t concerned about current market prices.
Even though, as he says, “the world economy is softening a bit…there’s always a chance of another recession. It’s been six years since the last recession started – they tend to come along with some regularity. Congress is now unable to get things done, and so we won’t have a good response if there’s another recession.”
With that being said, his favorite leading indicator for the market, housing permits, is not showing any signs of froth.
And he should know. The “bubble-hunter” famously predicted two of the biggest bubbles of all time: the dot-com bubble and the more recent housing bubble. In both cases, he published an edition of his book “Irrational Exuberance”, which forecast each bubble well before they occurred.
According to Shiller, there are no bubbles in sight. However, another Shiller indicator strongly suggests that a pullback is coming. His cyclically-adjusted price-earnings (CAPE) ratio is telling us that the market is currently expensive on a historical basis.
CAPE is calculated by taking the S&P 500 and dividing it by the average of 10 years worth of earnings. If the ratio is above the long-term average of around 16.5, the stock market is considered expensive. Shiller has argued that the CAPE is remarkably good at predicting returns over the period of several years.
Using Shiller’s formula, stocks are currently trading at 24.4 times their previous 10 years’ worth of earnings, well above the historic average of 16.5 going back to the year 1881.
But even though CAPE seems elevated at the moment, it’s not indicating that investors should dump stocks and hide in cash. The ratio is just telling us to be selective, be cautious, and expect lower returns for the next several years. Expect a correction, not a crash.
Credit Suisse’s Andrew Garthwaite often runs a chart of average 3-year forward returns for a given level of CAPE.
“We recognize that some investors are concerned that absolute valuations for U.S. equities are at elevated levels,” said Garthwaite the last time CAPE was at 24x. “This is the certainly the case on the Shiller P/E. However, we find current multiples have not necessarily been a precursor of falling markets. We note that markets are typically most vulnerable when the Shiller P/E is above 26x (compared to 24x currently).”
As you can see, once the CAPE ratio hits 26 market returns start to become negative on average.
So it is very important as individual investors to keep abreast of how this important indicator is doing.
The Nobel committee is rarely misguided, and they feel Mr. Shiller is worthy of a Nobel Prize based on his body of work, which includes the CAPE ratio and its growing importance. That should grab your attention.
I promise to keep you informed if and when the CAPE ratio hits the all-important number of 26. Until then, invest wisely.
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