CAPE Fear: The Shiller P/E Warns That Stocks Are Overvalued

The main U.S. stock market indices have recently smashed through record highs. The Dow Jones Industrial Average closed at an historic peak on Monday and the S&P 500 last week broke past 5,000 for the first time.

Are stocks as a whole currently overvalued and on the verge of a pullback? In an attempt to make that determination, there are many valuation yardsticks to choose.

Below, I focus on a time-proven valuation tool that I find particularly useful: the Cyclically Adjusted Price to Earnings (CAPE) ratio. The CAPE ratio is currently warning us that the stock market is indeed excessively valued. This conclusion is validated by other valuation gauges, notably the forward 12-month price-to-earnings ratio (FPER).

According to research firm FactSet, the FPER for the S&P 500 currently hovers at about 23. That’s pricey, when compared to the five most recent historical averages: five-year (18.9), 10-year (17.7), 15-year (16.1), 20-year (15.6), and 25-year (16.4).

What the CAPE ratio is telling us…

According to the widely followed CAPE ratio, stocks in the S&P 500 definitely sport excessive valuations (see the following chart, which depicts the latest CAPE data as of market close February 12).

Source: Professor Robert Shiller, Yale University

Professor Robert Shiller of Yale University invented the CAPE ratio to provide a deeper context for market valuation that takes into account inflation. The CAPE ratio is defined as price divided by the average of 10 years of earnings (the moving average), adjusted for inflation.

The CAPE ratio (also known as the Shiller P/E) provides a more meaningful context than the standard P/E ratio. The CAPE ratio now stands at 34.54, compared to the historical median of 16.52. You’ll notice from the above chart that the CAPE ratio has spiked near market crashes (e.g., 1929, 1987 and 2000).

The market appears frothy right now, but you should welcome a temporary pullback. When the investment herd panics, worthy but pricey stocks become affordable again. The market eventually bounces back. It always does.

Meanwhile, the latest inflation data came in hotter than expected, adding to market uncertainty.

The Bureau of Labor Statistics reported Tuesday that the consumer price index (CPI) rose 3.1% in January from a year earlier. That was more than the 2.9% increase expected by the consensus of analysts. Core prices, which exclude food and energy items, rose 3.9%. That was also above the 3.7% increase analysts expected.

Shelter prices were a major culprit for the hot CPI print. They account for roughly one-third of the CPI, by weight, and they climbed 0.6% from December and 6% year over year.

But price increases last month were across the board, reflecting “stickier” inflation than the interest rate doves have hoped. Inflation is clearly trending downward this year, but we’re likely to get bumpy readings along the way.

The CME Group’s FedWatch tool, as of Tuesday, placed 94.5% odds that the Federal Reserve would stand pat on rates at its next meeting March 19-20. Fed Chair Jerome Powell has definitively taken a March cut off the table.

The upshot: Stay invested but reduce your exposure to growth stocks (e.g., Big Tech) that have enjoyed a big run-up.

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Adhere to your long-term goals but gravitate toward value. Bullishness should not be synonymous with complacency. If Friday’s producer price index (PPI) report also comes in hot, the stock market may blow off some froth.

Keep an eye on the benchmark 10-year U.S. Treasury yield (TNX). If the yield continues its ascent above 4%, the rally will be in jeopardy. The stock market is highly caffeinated right now; a breather would be healthy.

Indeed, we got a selloff on Tuesday, when investors reacted badly to the CPI report. The main U.S. stock market indices closed lower as follows:

  • DJIA: -1.35%
  • S&P 500: -1.37%
  • NASDAQ: -1.80%
  • Russell 2000: -3.96%

Technology stocks, which of course are rate sensitive, were among the worst decliners. Small caps got crushed. The TNX jumped 3.45%, to settle at 4.31%. The CBOE Volatility Index (VIX) jumped nearly 14% to 15.86.

Tuesday’s CPI data took some air out of the equity market’s bubble. Wall Street nervously awaits Friday’s PPI report. We may not be out of the woods when it comes to inflation and elevated interest rates.

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John Persinos is the editorial director of Investing Daily.

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