The stock market has experienced a remarkable couple of months. Recently, the Dow Jones Industrial Average has seen a 12% increase since the end of March. The S&P 500 (^GSPC +0.02%) has climbed by 18.5%, while high-tech stocks in the Nasdaq Composite soared an impressive 28%, driven by excitement surrounding artificial intelligence (AI).
However, amid this excitement, there are some figures that warrant caution. One such number is the Shiller CAPE ratio, a widely used indicator of stock market valuation, which has recently surpassed 40 for only the second time in a century.
Understanding the Shiller CAPE Ratio
The CAPE (cyclically adjusted price-to-earnings) ratio essentially smooths out the price-to-earnings (P/E) ratio across the entire stock market. This involves dividing the price of the S&P 500 by the average inflation-adjusted earnings over the last decade.
A typical P/E ratio can be influenced by strong or weak years, but averaging earnings over ten years helps to eliminate short-term fluctuations and provides a clearer view of what investors are paying. A high CAPE ratio indicates that the market appears expensive compared to actual earnings. Historically, the average sits around 17, which suggests the current market is trading at more than double that long-term average.
CAPE Reaches a Peak Similar to the Dot-Com Era
The last time the CAPE ratio exceeded 40 was back in 1999, coinciding with the peak of the dot-com bubble. Over the past five years, the S&P 500 index has nearly tripled, fueled by a surge of speculation in internet stocks that often provided no substantial returns.
When looking at CAPE trends over the past century, it’s important to note that older data may not reflect the more than 40 current measurements yet.
What History Suggests About Future Returns
Historically, a significant increase in the CAPE ratio correlates with lower future returns. Robert Shiller, the Yale economist who created this index, found that when the ratio is above 30, average annual returns for the following decade generally fall to low single digits.
While there isn’t enough data for the range above 40, the existing information isn’t particularly promising. The parallels to the dot-com era are hard to overlook.
Just as in those days, the current markets are dominated by intense enthusiasm for cutting-edge technology, along with a collective belief that “this time is different.” Our stock valuations have escalated beyond reasonable justifications, essentially reflecting a market priced for perfection.
Navigating Forward as a Long-Term Investor
This doesn’t necessarily mean a market crash is just around the corner, or that any correction will be on the scale of Y2K, but it does serve as a cautionary signal.
History suggests a potential return to the situation of 2000, though definitive outcomes can’t be predicted. Even if a downturn does unfold, being correct about the crash doesn’t guarantee you’ll also know when it will happen—a crucial detail. Many observers predicted the dot-com bubble long before it burst, missing out on significant profits along the way.
Timing the market is notoriously difficult and often risky. The crucial takeaway from history is that for long-term investors, a disciplined and patient approach to investing has consistently proven to yield positive results.
