Today I’m going to tell you about the single most important metric for long-term investing.
That metric is the cyclically adjusted price-to-earnings ratio or CAPE ratio.
Generally speaking, most investors price a company based on its current Price to Earnings or P/E ratio. Essentially what you’re doing is comparing the price of the company today to its ability to produce earnings (cash).
However, corporate earnings are heavily influenced by the business cycle.
Typically the US experiences a boom and bust once every ten years or so. As such, companies will naturally have higher P/E’s at some points and lower P/E’s at other. This is based solely on the business cycle and nothing else.
CAPE adjusts for this by measuring the price of stocks against the average of ten years’ worth of earnings, adjusted for inflation. By doing this, it presents you with a clearer, more objective picture of a company’s ability to produce cash in any economic environment.
I mentioned before that CAPE is the single most important metric for long-term investors. I wasn’t saying that for impact.
Based on a study completed Vanguard, CAPE was the single best metric for measuring future stock returns. Indeed, CAPE outperformed
1. P/E ratios
2. Government Debt/ GDP
3. Dividend yield
4. The Fed Model,
…and many other metrics used by investors to predict market value.
So what is CAPE telling us today?
Today the S&P 500 has a CAPE of over 24. 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.
Indeed, as you’ll note in the above chart, the market has only been above this level three times in history. They were the 1929 Bubble, the Tech Bubble and the Housing Bubble.
All of these times occurred close to market peaks.
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, the fact is that the markets are significantly overpriced. And based on over 100 years worth of data, this kind of overvaluation usually precedes a market peak.
This doesn’t mean the markets will crash next week or next month. But it does pose a warning to those who are heavily allocated to stocks, expecting to see significant upside in the long-term.
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