The stock market’s oldest indicator just flashed red

Guest Post by Brett Arends

I hate to rain on this parade. But the latest lurch upwards in stock prices has just taken market valuations up into the skybox levels, according to the market timing measure with the longest pedigree on Wall Street. It’s just gone from flashing amber to flashing red — meaning, if it’s right, that there is now a significant and rising risk of a crash, and a bigger risk of simply very poor returns.

This has little to do with President-elect Donald Trump, by the way — and much more to do with President Ulysses S. Grant and all his successors.

Wall Street’s jump this week has taken the S&P 500 SPX, +1.32%  to an eye-watering 27.9 times the corporate earnings of the past 10 years. That’s according to data compiled by Yale finance professor Robert Shiller and some simple math.

This is about the same level that the market hit just before the crash of 1929, and is far higher than was seen in 2007, for example, or during the ill-fated boom of the late 1960s. The last time we saw the stock market this expensive on this measure was early in 2002 — just before stocks plummeted.

Comparing stock prices to earnings of the past 10 years, rather than just one year, is a metric known on Wall Street as the “cyclically-adjusted” price to earnings ratio, or CAPE. It is also known as the “Shiller” PE, after Yale’s Shiller, who won a Nobel prize for his research into it. His data shows it has been a strong indicator of future stock returns going back to 1871 and the days of President Grant.

Yes, CAPE has plenty of critics. Many people on Wall Street will tell you to ignore it, mainly, they say, because it’s been “wrong” for a long time. The CAPE has said stocks are overvalued since the mid-1990s, they point out. And yet shares keep going up.

Well, maybe. But as it happens a new research paper by two economists strikes a strong blow on behalf of the CAPE.

“Shiller’s PE: Market-Timing And Risk” by Valentin Dimitrov at Rutgers and Prem Jain at Georgetown shows that the biggest problem with the CAPE hasn’t been the metric itself — but the oversimplistic way investors have applied it.

Over the past 150 years, it has generally been an extremely poor move to invest in U.S. stocks with the CAPE at these levels.

In a nutshell: Investors shouldn’t flee stocks simply because the Shiller PE is above average. They shouldn’t flee stocks even when the Shiller PE is way above average. But history has said they should flee stocks when the Shiller PE is at extreme levels — like now.

Only when the CAPE is “higher than 27.6”, they conclude, has the stock market proven to be a really bad investment.

And, like I said, it just hit 27.9. According to Dimitrov and Jain, extremely high CAPEs like today have historically been followed by very high volatility, and really bad 10-year investment returns.

The difference between their analysis and the simplistic view of the CAPE is both real and meaningful.

As the authors note, most of the time even reasonably expensive stocks have been better investments than the alternatives, such as cash or bonds. Over the very long term stocks have handily outperformed other asset classes.

So, yes, history has said that the cheaper the CAPE when you invest in the stock market, the better your likely returns. People who invested when the CAPE was in single digits typically tripled their money or better over the next 10 years. People who invested when it was in the teens typically doubled their money or better. Even those who invested when the CAPE was in the low 20s typically made reasonable returns.

Only when the CAPE tops about 27.6 does it flash red, the authors calculate.

There are caveats. Permabull Jeremy Siegel, of the Wharton School of Business, argues that the usefulness of the CAPE has been weakened by accounting changes. And none of this relates to short-term, or even medium-term, trading. Early 1929 was actually a fantastic time to get into the US stock market — so long as you didn’t stick around. So were the late 1990s. Someone who sold their stocks in late 1996, when the CAPE hit 28, missed out on the biggest free-money bubble bonanza in recorded history. Veteran financial consultant Andrew Smithers, despite his prescient bearishness in 2000 and 2008, concluded that long-term investors should never hold about less than 60% of their portfolio in stocks.

Nonetheless, at this point history says you’d need another late 1990s dot-com-like mania to stay bullish. Over the past 150 years, it has generally been an extremely poor move to invest in U.S. stocks with the CAPE at these levels. But maybe this time is different, eh?