EVAN HOROWITZ | QUICK STUDY
The stock market has always crashed after reaching the kinds of highs we’re currently seeing, but that doesn’t necessarily mean it’s going to happen this time.
We could be in an era of soaring new possibilities, fueled partly by the recently passed tax cuts. Then again, perhaps “this time is different” is just the slogan people always use right before the fall.
To gauge the bubbliness of the current market, you need to look beyond the daily records, because those headline numbers aren’t adjusted for factors such as inflation and economic growth.
More useful is a measure called the CAPE price-earnings ratio — CAPE P/E for short — which tells you how stock prices compared with real-world earnings over the past decade.
Historically, when the Cape P/E is high, prices are ready to fall. And by this measure, it’s time for the parachutes.
Throughout the entire 20th century, prices in the S&P 500 averaged about 15 times higher than per-share earnings over the previous 10 years. Currently, share prices are 32 times higher than earnings.
Only one bull market in the last 140 years can boast a bigger outlier: the dot-com boom of 1999-2000. Even in the roaring 1920s, stock prices were more in line with underlying earnings.
Does this mean it’s time to sell? Maybe, but there are some big caveats.
It’s possible that large-scale changes in the economy and the investment landscape have made history increasingly irrelevant.
Take the recently passed federal tax cuts, which slashed the corporate tax rate from 35 percent to 21 percent. That alone should boost corporate profits, maybe even inaugurate a new era of consistently higher earnings. If so, it would throw a wrench in the price-earnings approach, which generally relies on the predictive power of past earnings.
Put differently, if we are entering a new era for corporate profits, then CAPE P/E might be misleading. Who cares if it’s telling us that stock prices are too high compared with previous earnings? What matters now is how those prices compare with estimated future earnings.
Wall Street has an answer to this problem, future P/E, which compares prices with projected earnings for upcoming quarters. And that number does indeed look less inflated — because it accounts for the fact that analysts expect earnings to rise significantly in the coming months. Which may be a reason to think current stock prices are actually sustainable.
Along the same lines, it also helps that there are no good alternatives. Bond yields are too low to tempt even wary investors, so their money will largely remain in stocks, providing a kind of buttress for current prices.
Plus, there’s a final problem for investors: timing. Even if they don’t buy the argument that we’ve entered a new era, it’s still hard to know whether now is the best time to sell. Get out too soon, and you may miss the final flourish, which could prove costly.
In the 1990s, the CAPE P/E flew past all historical highs yet still managed to maintain totally unprecedented prices for several years before the eventual crash. That’s because CAPE P/E is much better medium-term predictor than a short-term one. A statistical analysis from Oppenheimer Funds found that a high CAPE P/E almost always means lower returns over the course of five to 10 years, but not necessarily in the next one to two years.
Put all this together and it’s clear why investment decisions are so tricky, even for the well-informed. While the widely respected price-earnings approach suggests stocks are overvalued, compared with prior booms, it’s possible the lessons of history no longer apply — and even if they do, who knows when they’ll kick in.
If you’re looking for something to ease the worries about your retirement portfolio, try this: Overvalued stocks seem to lead to an increase in research and development, because companies have cash on hand to spend. Maybe someday we’ll discover that the next world-changing discovery was made possible by today’s inflated stock market.
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