“The CAPE ratio is a widely-followed stock market valuation and investing metric. And it is being talked about more as investors wonder whether stocks are poised to retrace in Y 2022. But, the signal of doom it sends is a myth“– Paul Ebeling
CAPE, or cyclically adjusted price-earnings, was popularized by Nobel prize-winning economist Robert Shiller. It is calculated by taking the price of the S&P 500 and dividing it by the average of 10 yrs’ worth of earnings. When CAPE is above its long-term average, the stock market is thought to be way overvalued.
Many market watchers use above-average CAPE readings as a signal that stocks should underperform or even fall as it reverts back to its long-term line. Fact is, CAPE’s line does not have much pull.
“While valuations feature importantly in our toolbox to estimate forward equity returns, we should dispel an oft-repeated myth that equity valuations are mean-reverting,” Goldman Sachs analysts wrote in a note to clients last wk.
The Goldie analysts did the math, and the Key metric to look at is the statistical significance.
The statistical significance over the full sample is 26%. This means that there is only 26% confidence that the Shiller CAPE is mean-reverting, and 74% confidence that it is not. The traditional threshold to consider a relationship statistically significant is 95%.
In other words, you can’t rely on CAPE to gravitate toward any mean.
The GS analysts took issue with the concept of the CAPE ratio in general.
“Even if we ignored this threshold, the time between valuations crossing into their 10th decile and reverting to their long-term average is beyond a reasonable investment horizon for a tactical decision,” they said. “For example, the Shiller CAPE entered its 10th decile in August 1989 but did not revert to its long-term mean for 13 years.“
In other words, trading based on the assumption CAPE will mean-revert could lead to indeterminate yrs of getting smoked by the market.
Valuation metrics like CAPE and forward P/E offer a simple way of estimating the premium an investor pays for a company’s earnings so it is not totally worthless.
But, is does not do a super job of telling investors what stock prices will do in the coming days, months, or yrs. So tune out the Noise!
Have a happy, prosperous holiday weekend, Keep the Faith!