The cyclically adjusted price/earnings ratio is quite elevated compared to historical standards. Is that bad news for stocks? Charles Schwab’s Liz Ann Sonders says it’s a complicated question.
“The CAPE is a great tool to keep in the valuation toolbox when judging the likely long-term returns for the stock market,” Sonders writes in recent commentary. “But where it can fall short is as a shorter-term market timing tool; especially by investors following it dogmatically.”
Sonders says that the CAPE, which uses ten-year, inflation-adjusted earnings for the P/E’s denominator, has some flaws. “The problem with using a 10-year period for earnings is that the average US business cycle has been a lesser six years or so,” she says. “Both accounting standards and corporate taxation policies have changed significantly over time,” she adds. “Public accounting in the United States was still in its infancy in the late-1800s [when historical stock return data begins] and it’s questionable how useful these early earnings numbers are to any analysis using them as inputs.” And the CAPE includes non-recurring earnings items that may have been anomalous to a particular period and not indicative of what will happen in the future.
Sonders says the market can continue to rise long after the CAPE gets elevated. It exceeded its average just two months into the current bull market, for example. But, she says, “It has a strong long-term relationship to subsequent 10-year stock market returns. I would not quibble with the notion that the market’s returns in the next 10 years could be lower than normal.”
Sonders also looks at shorter term P/E ratios, as well as the potential impact of interest rate hikes on valuations.