Wallet Hacks

CAPE: How to tell if the stock market is over-priced

Ever wonder if the stock market is expensive or cheap?

If you rely on mainstream media to tell you, you're making a huge mistake.

Ever hear the line “if it bleeds, it leads?”

It perfectly encapsulates what the “news” is all about. It's not about getting information to you, it's about getting you to watch. The more people watch, the higher the ratings. The higher the ratings, the more they can charge for commercials.

Just go back to articles from six months ago, read the “predictions” and see how they panned out. A Trump presidency was going to sink the market… but instead it went on a tear.

They have crazy headlines about how the Dow is going to break 20,000 (!!!) and how the market is over-valued. By the way, it broke 20,000 earlier this year. It's broke 21,000 recently too — but we've been recently gyrating around 21,000.

(incidentally, the Dow Jones Industrial Average is just an index of 30 companies and is a terrible index if you want to think about “the market”)

Kick the hype machine in the shins.

If you need one simple number to know whether the stock market is overvalued – I have it. It's what the pros use and if you give me a few minutes, I'll explain it to you so you will be better informed. It was a revelation to me when I learned it.

It's called the CAPE.

What is CAPE?

CAPE stands for cyclically-adjusted price-earnings ratio.

I'm going to go through the idea very quickly, then break it down using some numbers. Most of my knowledge on this is based on a great explanation by Mathieu Bouville, PhD, on his post here. I hope I can explain it more simply, though his explanation is great if you're willing to read it (and you should).

The only way to tell if the market is over-valued is to compare it's P/E to historical values, typically within the last 10 years. If the P/E of the market is higher than it's average the last ten years then it's overvalued.

A simple example using oranges:

Jimmy is selling oranges today for $26 each. The news would have you believe that Jimmy is making a fortune! Look at the price! $26! Who pays that much for oranges?

That's because your biases look at the number ($26), look at the product (an orange), and think that $26 for an orange is absurd.

But if oranges have been selling for $36 the last ten years, Jimmy's oranges are cheap! (or something's wrong with his oranges!)

If they were selling for $16 for the last ten years, then you'd be crazy to buy Jimmy's oranges. Unless you really really really needed an orange.

The only reason you believe it's expensive or cheap at $26 is because you have a general idea of how much an orange costs.

How does that example apply to the stock market? The stock market has a historical price. It's called a P/E.

P/E is price to earnings ratio, or the price per share divided by the earnings per share each year. If Jimmy Oranges Inc. makes $5 a share and the stock market values each share of the company at $25, then the P/E is 5. If Jimmy Oranges Inc. is a sexy orange-y startup that makes no profit, then earnings are $0 and P/E is 0 (technically it's infinite… or not a number since you cannot divide by zero).

To get a historical look at prices, we use CAPE (cyclically-adjusted price-earnings ratio). Don't get bogged down by the cyclically-adjusted part, that just means we average it over an economic cycle so you're not making the mistake of looking at a boom or bust period.

With CAPE, we're talking about the CAPE of the S&P 500 (forget the DOW, that's junk) and a look back period of 10 years.

The historical average of the S&P 500 CAPE is 16.4 (the median was 15.8). Half the time it's been between 11.6 and 19.7, so anything lower (bottom 25%) is cheap and anything higher (top 25%) is expensive. (you can look it up here)

That is an objective measure that you can't dispute. If you could historically buy earnings at 16.4x, then paying more makes it expensive. There's no judgment call here on whether it's a good or bad decision to pay more than 16.4x.

If you make regular contributions to your retirement and into an S&P 500 index fund, you're smart for doing it but you're just paying a little extra when the CAPE is over 16.4. It's better that you invest immediately than try to time the market and wait for the CAPE to dip (because it might now).

An Ominous CAPE Chart

Notice two recent Red Dots missing? The peak for the Dot Com Bubble and the start of the Great Recession.

Scary huh? Hold onto your butts.

So what?

The CAPE, as of this publishing, is over 29 (in fact, when I started working on this post a few months ago, the CAPE was just over 26).

The S&P500 is expensive.

Mathieu Bouville went back and looked at the performance of the stock market and found that the CAPE had some predictive power. He even suggests an investment strategy based on the CAPE.

The gist of that is that when the CAPE is below 11.6, hold 100% stocks. When it's above 19.7, hold 100% bonds. In between, it's a linear function. He suggestions that based on CAPE, you should be adjusting your stock to bond allocation – and he's probably right.

But wait! There's more.

But there are non-zero costs to changing and based on your assets. (commissions, taxes)

So how can you use this without monitoring your allocation so often?

The best use of this is an idea I read on Can I Retire Yet? by Darrow Kirkpatrick. His post analyzes the best retirement withdrawal strategies (and his follow-up confirms it) suggests that when you need your retirement money and are picking which assets to sell, you can use CAPE to help. If CAPE says the S&P 500 is overvalued, sell those assets first. If it says the S&P 500 is undervalued, sell bond assets first.

The corollary to that is that if you're in accumulation mode (putting new money into the market), recognize that you cannot assume new money into the S&P will grow at the standard assumption of 7-10% per year. You may want to put it into bonds until the CAPE recovers, using a version of Bouville's strategy. Then adjust back to your target allocation when things are less frothy.

I don't mean to imply that you should time the market but you need to be reasonable in your assumptions given the state of the market.

I think that's the best use of the CAPE… besides impressing your nerdy friends at dinner parties when they're talking about the stock market.