CAPE Update (Or, was Last Week’s 5.6% Market Pop Justified?)

As of July 1, 2011, the Cyclically Adjusted PE (CAPE) ratio for the S&P 500 is 23.13, which essentially means the average share of common stock in the S&P 500 companies trades for 23.13 times its annual earnings averaged over the previous ten years. (The data for the attached chart was taken from Professor Robert Shiller’s website at Yale.) Excluding the dot com fueled market in the late 1990s and the housing credit fueled market before 2008—each of which ended badly—the CAPE is as high as it has been since January 1966.


In the sixteen-plus years from January 1966 to August 1982, the index value of the S&P 500 dropped 61.74% after adjusting for inflation. Real total returns would not have been as bad as that because investors would have collected dividends over that period, but the results are still dismal.

The CAPE has been a reliable indicator of long-run returns for the US stock market. It is impossible to say that a large market correction is imminent, but few could argue that the prospects for real returns in the US stock market are rosy especially when Tobin’s Q ratio, which measures market prices relative to corporate book value and is another reliable long-term indicator, is at an all-time high (excluding the dot com era but including the housing bubble).

When there are so many known economic pins bouncing around that could deflate this market quickly, and many more pins that our imagination is weak at identifying, what is driving it upward? That question is especially pertinent to those companies whose P/E, P/B, and P/S ratios are in the stratosphere such as OPEN and NFLX. The graveyards are full of companies that once flew high on growth prospects alone.

Last week’s 5.6% market pop on little news is a mystery. Unfortunately for the cautious among us, it looks like a mystery that may continue to play.

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