The stock market is pretty expensive. This becomes clear when you compare current stock valuations with those from previous eras.
But it’s also true that stock prices are pretty reasonable right now.
This seemingly contradicting conclusion comes when you factor in other important factors: interest rates and inflation, both of which are extremely low.
On its own, stock valuations are staggering but far more attractive when placed alongside bonds. This is why it is so difficult to tell whether the stock market is dangerously high or a relative bargain.
Keep in mind that the S&P 500 index of US stock prices has repeatedly set records over the past year, while one of the metrics I helped shape, the CAPE rate for the S&P 500, is also at a high level.
In my view, the CAPE rate is the more important of the two overvaluation measures as it corrects inflation and long-term corporate earnings. John Campbell, now at Harvard University, and I defined CAPE in 1988. This is a bit technical, but please note: the numerator is the share price per share adjusted for consumer price inflation, while the denominator is an average over the last 10 years of corporate earnings per share, also adjusted for inflation.
Why bother looking at the stock market with the CAPE rate? Averaging earnings over 10 years smooths out year-to-year fluctuations and provides an earnings estimate that for most companies should be a better measure of long-term fundamental value. This 10-year average of real earnings isn’t quite as up-to-date as the latest earnings data, but it does offer a more sober assessment of companies’ profitability.
A high CAPE suggests that the market is overpriced, which suggests low future returns, while a low CAPE suggests the opposite. Professor Campbell and I have shown that the CAPE ratio enables us to forecast over a third of the variance in long-term returns in the stock market since 1881.
The CAPE rate is currently at 35.0, well below its highest level of 45.8, which was reached on March 24, 2000 at the height of the millennium stock market boom. The market fell sharply shortly thereafter and the CAPE fell a long way, hitting a cyclical high of 35.7 on February 12th. Its current range is the second highest since our data began in 1881.
The market is clearly expensive compared to previous eras. According to calculations by Barclays Bank, this high pricing of the shares is characteristic of the US market today, which has the highest CAPE ratio of 26 large countries. This inequality has persisted despite the 2020 pandemic and the January 6th unrest and occupation of the U.S. Capitol.
What does the CAPE rate tell us? I believe it is an excellent tool for analyzing price levels, but its predictive power is limited.
Imagine our job is to bet on whether a flying bird will be higher or lower in an hour. It is impossible to really accurately predict the bird’s flight. The momentum could be relied on to extrapolate its path for a few seconds, but after that the bird will do what it wants to do.
That is, if the bird is very high in the air, gravity assures us that it will eventually come down. And because it spends most of its time at lower elevations, betting that the bird will sink is a solid bet, but there’s a good chance it’s wrong. This is exactly what CAPE helps us with stock market analysis. It is said that the market is high now, but also that it could stay that way for some time.
However, the CAPE measure of stock market performance may not be the most relevant right now.
Ask yourself another question: what better, safer place to make money selling stocks?
Let’s stick with the bird metaphor a little longer. Now there are two birds. One represents stocks, the other bonds. Which bird is more likely to fly higher? The bond bird also flies quite high. (Bond prices are increased because interest rates are very low and bond prices and interest rates are moving in opposite directions.)
To answer this question – to compare the likely future returns on stocks and bonds – my colleagues Laurence Black of Index Standard and Farouk Jivraj of Imperial College London and I have found another measure. We call it the Excess CAPE Return, or ECY
Put simply, the ECY tells us the premium an investor could expect if they invest in stocks through bonds. It is defined as the difference between the reciprocal (or inverse) of CAPE – that is, the average annual real profit over 10 years divided by the real price – and the real long-term interest rate.
The ECY is currently 3.15 percent. That’s roughly the average for the past 20 years. It’s relatively high and predicts stocks will outperform bonds. Current bond rates make this a very low hurdle.
When you factor in inflation, the 10-year Treasury bill will most likely pay off less in real dollars than your original investment, with a yield of around 1.4 percent on maturity. Stocks may not have the usual high long-term expectations (the CAPE tells us), but there is at least a positive long-term expected return.
All in all, I would say the stock market is high, but nonetheless, in some ways, more attractive than the bond market.
For those overexposed to equity risk, it might be worth selling some stocks now in favor of bonds. Treasury bills, for example, will most likely keep their face value. In a time of stable inflation, they are generally safer than stocks.
For most people, a well-diversified portfolio that includes both stocks and bonds is generally a good idea. Additionally, stocks may be more attractive than bonds because when the economy picks up there can be fears of inflation too. This could help stocks fly higher and cause bonds to perform poorly.
Markets may be dangerously high right now, and I wish my measurements gave a clearer indication, but they don’t. We cannot accurately predict the instantaneous movements of birds, and unfortunately the stock and bond markets are similar.
Robert J. Shiller is a Sterling Professor of Economics at Yale. He is an advisor to Barclays Bank.
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