Stocks Shouldn’t Be This Pricey, Even If We’re Being Generous

Stocks Shouldn’t Be This Pricey, Even If We’re Being Generous
Stéphane Renevier, CFA

almost 2 years ago1 min

The Shiller cyclically adjusted price-to-earnings (CAPE) ratio is a long-term measure of stock valuations: the price-to-earnings ratio, but smoothed over a broader horizon to account for variations in the business cycle. And according to the metric, stocks have only been more expensive than they are today on one occasion: at the top of the dotcom bubble in 2000.

Some investors would argue that those higher prices are justified, claiming that the “fair value” of a stock – that is, what it’s really worth based on intrinsic and extrinsic factors – should grow exponentially over time. They’d argue that things like productivity increases over time, financing costs come down, and so on. So let’s assume they’re right: if the fair value CAPE (dotted line) was around 14x earnings in the early 1900s, it should now be around 21x based on the exponential growth trend. It’s actually around 39x – 87% higher than the trend.

So even if you account for an exponential growth in fair value, US stocks are still way too expensive right now. What’s more, the deviation from the trend is as wide as those that have preceded past crashes. In that light, it’s easy to see why stock prices might be in for a sharp decline.

Of course, you could bet that things will be different this time. But personally, I’d assume that US stock valuations will eventually revert to trend, as they so often do. So if you have a long-term horizon, selling some of your US stock holdings and buying into stocks from cheaper regions (such as Europe or China) or more defensive sectors (such as energy or healthcare) would help protect you from the fall.

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