The market is overpriced, to be sure. I’m gauging this on the single most important valuation metric in finance: 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 24 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 24 years to make your money back.
That’s expensive. Indeed, the market has only been this expensive a handful of times in the last 100+ years. Every time we’ve been closer to a market top than a new bull market run.
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