Don't Overlook This Fundamental Stock Signal

The CAPE ratio is currently rising fast towards 40

Senior Quantitative Analyst
Dec 1, 2021 at 8:00 AM
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I typically focus on technical or sentiment indicators, but this week I am looking at a broad-based fundamental indicator -- the Shiller S&P 500 price-to-earnings (P/E) ratio, also known as the CAPE (Cyclically Adjusted Price-Earnings) ratio. It basically is the P/E ratio of S&P 500 Index (SPX) stocks, but it evens out earnings by looking back 10 years, and adjusting them for inflation.

There is monthly data for this ratio going back to before 1900, though I did not look into  how they calculated it before 1928, which is as far back as I have seen SPX data. There have only been three time periods in which this ratio broke 30. The first was in 1929, just before the Great Depression. The second time was in 1997, when it continued rising to a record high of nearly 45, until the tech bubble crash in the early 2000s. Then, it moved above 30 in 2017, and is now rising fast toward 40.

Next, I will show you what kind of returns stocks produced given the level of the CAPE ratio.

IotW Nov30 Chart 1

What History Tells Us

The first table below shows annualized SPX returns after CAPE ratio readings above 25. For a benchmark, the SPX averages about 8% every year since 1928. When the CAPE ratio has been above 25, however, the index averages roughly 3.9% over the next year. The longer-term returns are more concerning, with the SPX averaging an annualized return of under 2% during the next five years, and being positive less than half of the time.

The second table shows SPX returns after the CAPE ratio reading was below 10. These low ratios lead to significant outperformance, with the index gaining an average of 18.8% over the next year, with 84% of the returns positive. Looking at the five-year returns, it averaged 13% on an annualized basis, with 100% of the returns positive.

IotW Nov30 Chart 2

Up next is table showing SPX returns between these two extremes.

IotW Nov30 Chart 3

Why Options Might Be a Good Choice Right Now

The chart below highlights the disparity of average annualized returns going forward, based on the CAPE ratio. If this tendency holds up, it could be a rough go for buy-and-hold investors over the next several years. Maybe I am biased, but it is a good reason to shorten time horizons, perhaps using options. Plus, when the CAPE ratio moved above 30 in 1997, there were still a few years of substantial gains left before the ultimate top.

Here is why things might be different this time. Since the start of the pandemic, the Fed has created a lot of new money. Although the earnings in the denominator of the CAPE ratio is inflation-adjusted, price inflation has not kept up with the pace of money creation.

The new money might have a bigger impact on the price in the numerator, depending on how much of that money is directed into the market. If that is the case, the CAPE ratio will settle around a higher normal reading for a prolonged period of time, before price inflation catches up. So, there are reasons to be hopeful.

IotW Nov30 Chart 4

 

 

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