[size=3]With the Graham/Shiller PE-10 (or CAPE) Ratio at 30.09, Stocks Certainly Aren’t Cheap[/size]
This chart shows the Graham/Shiller 10-Year S&P 500 CAPE Ratio for 1871-to-June 22, 2019:
You can see that at a level of 30.09 (designated by the red dot on the far right), the S&P 500 remains at a valuation that is higher than at nearly any prior time in the last 148 years. That’s significant!
While prices shot up sharply higher, to a CAPE-10 of about 44 at the peak of the dot-com bubble in 2000, they reverted sharply back to their mean as stocks sold off -50% in 2001-2003 and then again by -56% from 2007-2009. Most recently, CAPE-10 series had returned to a high of 33.31 on January 1, 2018. Valuations dropped a bit as prices came down throughout the 2018 turbulence but have generally been flat for the last 18 months, in a narrow (and high) CAPE range of 28 to 33.
VALUATIONS CAN’T BE USED FOR TIMING…
High valuations do not mean that there is an immediate danger in the market of a downturn. To the contrary, valuations are a notoriously weak timing signal to identify when the next selloff will occur.
…BUT THE RELATIVE LEVEL OF VALUATIONS CAN BE A GUIDE FOR THE SEVERITY OF THE COMING SELLOFF
However, how far valuations are extended above or below the long-term, valuation average (at about 15) can give us an idea of how far stocks will have to move when the inevitable economic slowdown or rally takes place. Historically, the S&P 500 and other indices have always returned to their long-term PE mean at 15. But since 1990, prices and stock’s PEs have remained elevated without a trip into the undervalued territory below 15. Nevertheless, prices and PEs are still returning back to at least the PE Mean level (at 15), despite requiring two efforts over a decade to accomplish the feat.
Mild or moderately high valuations suggest that the end of the business cycle (they haven’t been repealed yet!) will not result in wholesale hysteria and stockbrokers jumping from the buildings in the vicinity of Broad and Wall Street. Mild or moderately extended valuation levels means that stocks don’t have so far to fall when the tide turns and an economic contraction begins.
On the other hand, extreme valuations – such as occurred in 1929, 2000, 2007, and today – means that the pain is going to be widespread and the resulting crash will have a devastating impact on the finances of many investors when the economic downturn occurs. Today’s S&P 500 valuation is actually higher than the level attained in 2007, just before the US Financial Crisis tore a hole in the world economy and we saw the S&P 500 lose -56% in 18 months – requiring 5-1/2 very long years to return back to breakeven!
The following chart shows both the overvalued conditions and the undervalued conditions relative to the long-term, Price/Earnings mean of 15 (dotted-blue centerline). When overvalued conditions became extreme, the dotted red downward arrows show the distance that stocks needed to fall to return to average. When prices became deeply undervalued, the dotted-green upward arrows showed how much was needed in the rally to return to the average. You can see that sometimes this was a two-step process to play out completely, such as the 2000-to-2003 dot-com crash, followed by a few-year break, then another selloff from 2007-to-2009 to complete the process and return (briefly) to the CAPE 15 level – i.e., ‘Ground Zero.’
Notice that since 1990, the CAPE or Shiller-PE-10 Ratio has been well above the long-term, historical average PE of 15. Since 1990, the average CAPE ratio has been closer to 25. Has there been a fundamental change that increased the valuation of corporate stocks in the last 29 years? …Or do you think that the law of averages means that stocks will enter into a new paradigm at some point where they will remain undervalued for an equivalent 29-year period?
Food for thought…
Chris