The purse is already quite expensive. This is evident when you compare current valuations of stocks with those of previous eras.
But it’s also true that stock prices are pretty reasonable right now.
This seemingly contradictory conclusion comes when you include other important factors: interest rates and inflation, both of which are extremely low.
Looked at in isolation, stock valuations are at sky-high levels, but they are much more attractive when viewed alongside bonds. This is why it is so difficult to determine if the stock market is dangerously high or a relative boon.
Consider that the S&P 500 index of US stock prices has repeatedly set record highs over the past year, while a metric I helped create, the CAPE ratio for the S&P 500, is also at high levels.
In my opinion, the CAPE ratio is the more important of these two overvaluation measures because it corrects inflation and long-term corporate profits. John Campbell, now at Harvard University, and I defined CAPE in 1988. It’s a bit technical, but be patient: the numerator is the stock price per share corrected for inflation. consumption, while the denominator is an average over the last 10 years of earnings per share reported by the company, also adjusted for inflation.
Why bother looking at the stock market with the CAPE ratio? The 10-year earnings average smooths out year-over-year fluctuations and provides an estimate of earnings that should be, for most companies, 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 provide a more sober assessment of corporate earnings power.
A high CAPE ratio suggests that the market is overvalued, portraying low subsequent returns, while a low CAPE suggests otherwise. Professor Campbell and I have shown that the CAPE ratio allows us to predict more than a third of the variance of long-term returns in the stock market since 1881.
The CAPE ratio stands at 35.0 today, 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 soon after, and the CAPE rallied much of the way back, hitting a cyclical high of 35.7 on February 12. Its current range is the second highest since our data began in 1881.
Unequivocally, the market is expensive compared to times past. This high stock price is now unique to the US market, which has the highest CAPE ratio of 26 major countries, according to Barclays Bank calculations. This disparity has continued despite the blows of the 2020 pandemic, and civil unrest and the occupation of the U.S. Capitol on January 6.
What does the CAPE ratio tell us? I think it’s a great tool for analyzing price levels, but its predictive ability is limited.
Imagine our task is to bet that a flying bird will be higher or lower in an hour. It is impossible to accurately predict the flight of the bird. You could count on the momentum to extrapolate its trajectory for a few seconds, but after that the bird will do what it wants to do.
That said, if the bird is very high in the air, gravity assures us that it will eventually descend. And since it spends most of its time at lower altitudes, betting when the bird will decline is a solid bet, but chances are it is wrong. This is essentially what CAPE helps us do for stock market analysis. He says the market is high now, but also that it may remain so for a while.
However, the CAPE measure of stock market performance may not be the most relevant right now.
Consider a different question: is there a better, safer place to make money if you sell stocks?
Let’s stick to the bird metaphor a little longer. Now there are two birds. One represents stocks, the other represents bonds. Which bird is most likely to fly higher? The leaping bird flies quite high too. (Bond prices are high because interest rates are very low and bond prices and interest rates move in opposite directions.)
For an answer to this question – for a comparison of likely future returns on stocks and bonds – my colleagues Laurence Black at the Standard Index and Farouk Jivraj at Imperial College London and I have proposed another measure. We call it the CAPE excess return, or ECY
Simply put, the ECY tells us the premium an investor might expect when investing in stocks versus bonds. It is defined as the difference between the inverse (or the reverse) of the CAPE – that is, the 10-year average annual real earnings divided by the real price – and the real long-term interest rate.
Currently, the ECY is 3.15%. That’s about his average for the past 20 years. It is relatively high and it predicts that stocks will outperform bonds. The current interest rates on bonds make this a very low barrier.
Consider that when you factor in inflation, the 10-year T-bill, which has a yield of around 1.4%, will likely pay less in real dollars at maturity than your original investment. Stocks may not have the usual high long-term expectations (CAPE tells us), but at least there is a positive long-term expected return.
Putting it all together I would say the stock market is high but still in some ways more attractive than the bond market.
For those who are overexposed to equity risk, selling some stocks now in favor of bonds might be worth it. Treasury bills, for example, are very likely to hold their face value. In a period of stable inflation, they are generally safer than stocks.
But for most people, a well-diversified portfolio containing both stocks and bonds is generally a good idea. In addition, stocks may be more attractive than bonds because if the economy recovers, so can the fear of inflation. This could help stocks fly higher and cause bonds to perform poorly.
The markets may well be dangerously high right now, and I would like my measurements to provide a clearer indication, but they are not. We cannot accurately predict the moment-to-moment movements of birds, and the stock and bond markets are, unfortunately, much the same.
Robert J. Shiller is Sterling Economics Professor at Yale. He is a consultant for Barclays Bank.
