Sunday, December 07, 2014

The CAPE ratio

The CAPE ratio is currently around 27, which makes the following fact all the more worrisome: Before this year, the CAPE ratio has been higher than 25 in only three periods – the years clustered around 1929, 1999, and 2007.

You don't have to be a stock market historian to know what those years featured – market peaks followed by big bear markets. When framed that way, it seems that a CAPE ratio above 25 should be an automatic warning sign.

But that's only half the story. A closer look at the data shows that the market can do quite well even when CAPE ratios exceed 25:

Year
CAPE Ratio (on January 1)
S&P 500 Return
1997
28.33
+31.01%
1998
32.86
+26.67%
1999
40.57
+19.53%
2004
27.66
+8.99%
2005
26.59
+3%
2006
26.47
+13.62%
2007
27.21
+3.55%

Shiller himself admits the limitations of CAPE as a forecasting tool, in his article he plainly states that "the ratio has been a very imprecise indicator" and that it was "never intended to indicate when exactly to buy and sell."

With the CAPE ratio hovering around 27 now, it's certainly not something to completely ignore. But we also know that stocks can remain "overvalued" for several years before reverting to the mean.

-- ZIM Weekly Update, 12/7/14

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