What Is The CAPE Ratio And What Does It Mean For Stocks?

In our last post, we looked at what Dr. Steve Sjuggerud of Stansberry Research had to say about the current valuation of US stocks using the P/E ratio. By digging into the numbers a little further and looking at analyst forecasts for continued strong profit growth over the next two years, Dr. Sjuggerud suggests that the current market isn’t expensive at all, and in fact is possibly undervalued relative to future earnings.

What Is a CAPE Ratio?

But the P/E ratio isn’t the only measure of potential market value. Another evaluation methodology is the Cyclically Adjusted Price-to-Earnings (CAPE) ratio. And according to an analysis conducted by Dr. Sjuggerud, US stocks once again could actually be cheap.

The CAPE ratio is a tool used to help assess the stock market’s overall valuation. It does so by comparing the US stock markets current market level, and dividing it by preceding ten years of earnings, adjusted for inflation.  This method of analysis is designed to smooth the effect of short-term fluctuations in earnings and gauge whether US stocks, in general, are potentially presently over- or undervalued. US economist Robert Shiller invented this methodology 25 years ago, and it has tended to accurately predict periods of strong and weak market performance.

Predictions

Analysist are predicting that the US market’s strong earnings growth in 2018 will make a big difference to the CAPE ratio, which is true enough – but they may be overlooking the change that will affect the tail end of these ten-year figures.

Today’s CAPE ratio covers the period from 2009-2018. You’ll notice that includes the GFC year of 2009 and that is holding back the ‘E’ in the CAPE ratio today.

But by the end of next year, the CAPE ratio bumps up a year to cover 2010-2019 – that is, the robust earnings of the last 12 months will be added to the calculations, and the terrible single-figure earnings growth of 2009 will disappear.

Naturally, this new set of figures will bring the CAPE ratio significantly lower. Dr. Sjuggerud suggests that when the anomaly of the GFC is removed from the CAPE ratio’s 10-year review of corporate profits, the updated 2020 ratio will likely fall substantially and is another indicator that suggests that the market may, in fact, be undervalued rather than overvalued, as many commentators appear to suggest.

Coupled with Monday’s discussion of the P/E ratio and its future assessment of the US stock markets value, investors buying today might be surprised with how well they could actually do.

If you would like to speak with a professional investment adviser about how your portfolio is positioned for the year ahead, contact United Global Capital today on 03 8657 7640 or email [email protected] for a no cost, no obligation consultation.

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