It’s never a good idea to chase a financial bubble. But how is one to know if the market is overvalued? How does today’s market compare to 1929 and 2000 (two years that were followed by terrible market performance)?
The Price-to-Earnings (p/e) ratio is a common metric for understanding whether or not a stock is expensive. Essentially, it measures how much (price) you have to pay for each dollar of profit (earnings) the company makes. The more you have to pay per dollar of profit the more expensive the stock. In other words, a high p/e ratio stock is more expensive than a low p/e stock.
The p/e ratio is a simplistic measure, and is only one data point in an analysts arsenal to evaluate a stock. The problem with p/e ratios is that it doesn’t adjust for potential earnings growth. Another problem is it often only considers the most recent price and last 12 months of earnings data.
A Better Valuation Metric: CAPE Ratio
A similar valuation metric is the Shiller p/e, sometimes referred to as the Cyclically Adjusted P/E (CAPE) ratio. The CAPE ratio – developed by Professor Robert Shiller – adjusts for the regular p/e ratio’s short term bias by incorporating 10 years of earnings data. Using the longer data series helps smooth out fluctuations caused by the business cycle.
Analysts use the p/e and CAPE ratio to help them analyze individual stocks. But at DumbWealth.com we don’t condone stock picking, for the most part. We want to keep things simple and set our readers up for success. This usually means buying low-cost ETFs that provide access to entire markets or sectors.
From this perspective, it is still important to have a sense of where the market valuation sits relative to history. The chart below (sourced from Professor Robert Shiller’s website) plots the CAPE ratio and interest rates dating back to the late 19th century. As you can see, while the CAPE ratio is nowhere near its 2000 and 1929 peaks, the valuation metric is clearly elevated relative to its history.
The chart below breaks down the regular p/e and CAPE ratio by sector. You can see how certain richly-valued sectors (e.g. Real Estate) pull the overall market valuation metrics up.
By now you might believe the market is overvalued. You could be right, you could be wrong. The problem is that both the p/e and CAPE ratios don’t adjust for the level of interest rates. Lower interest rates means that the present value of future earnings is worth more, thereby justifying higher valuations. How high is too high? Nobody knows.
So What is One to Do?
If valuation metrics were at 2000 or 1929 levels, I think it would be rational to be deeply concerned about valuations. However, the market is a long way from those levels. That’s not to say the market cannot fall – the 2008/2009 bear market occurred at a time when valuations weren’t exorbitant.
At current levels, I don’t think one can base investing decisions off valuations alone. For those with a long-term investing horizon, the most prudent approach is the following:
- Don’t attempt to time the market,
- Determine your personal strategic asset mix (more on that to come), and
- Build a portfolio of low cost ETFs that align with that mix.