Expensive Markets and Real-World Trouble

The years 2000, 2007, and 2022. Three market declines, three very different causes, but one common warning sign. In each case, the market entered the downturn from a place of elevated valuation.

That is where the Shiller CAPE ratio becomes useful.

Robert Shiller was awarded the Nobel Prize in economics for his work on why markets can become disconnected from fundamentals for extended periods. It followed his previous work on market valuation and the long-run stock market outlook, with the CAPE ratio being the most recognized.

The CAPE ratio, short for Cyclically Adjusted Price-to-Earnings, looks at the price of the market relative to the average of the last 10 years of inflation-adjusted earnings. It was innovative because a normal P/E ratio can be distorted by one strong or weak year. CAPE attempts to smooth that and give us a better sense of what investors are paying for a more normalized stream of earnings.

It is not a perfect measure. No valuation tool is. But it was built to answer an important question: Is the market priced for its longer-term earnings power, or might we expect lower returns?

The CAPE is often misunderstood or misused.

The ratio is not a countdown clock for market crashes. It does not tell us when to sell, and it does not reliably predict the precise start of the next bear market. Expensive markets can remain expensive for quite a while.

But when CAPE is high, it means future returns are more likely to be lower than investors have grown used to. It means the margin for error is thinner, and a plan deserves another look.

The current Shiller CAPE ratio is about 39.7 compared to a long-run median of 16, which places stock valuations at a historically elevated level. Its all-time high was 44.2 in late December 1999, the beginning of a severe market downturn.

A high CAPE should lead to better questions. Are our return assumptions realistic? Are we taking more risk than we need to for the expected return and volatility? Are there other income sources or asset classes that may offer a better risk-adjusted return?

That is the lesson of 2000, 2008, and 2022. The causes of those declines were different, but high starting valuations left less room for trouble. Seems relevant today. A good plan should hold up even when future returns are less generous.