In July, the Shiller CAPE ratio crossed above 42 for the first time since July 2000, when the S&P 500 had just begun its 50% decline from the nauseating heights of the dot-com bubble
Because of its impressive track record of predicting long-term returns, the metric is well regarded by both perma-bears and mainstream Wall Street strategists alike
In a client note on Thursday, Rosenberg Research’s David Rosenberg, who frequently expresses bearish views, said the indicator shows that outside the dot-com era, “this is the most overpriced S&P 500 in recorded history.”
A couple of years back, former Goldman Sachs strategist David Kostin warned that a high CAPE ratio would lead to very poor annualized returns of 3% over the next decade
That said, the CAPE ratio hitting fresh 26-year highs may be a bit panic-inducing
Sure, the measure isn’t supposed to be a good predictor of near-term returns, but recall the steep decline in stock prices that came right when it was last this high. And even if no big crash is imminent, the prospect of collecting next-to-nothing in returns over the next decade is arguably just as scary
But there are plenty of reasons not to worry. Despite its credentials, the CAPE ratio isn’t perfect and has its detractors
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You can probably pick out a big flaw just by looking at the above chart — that is, valuations have been high for a pretty long time now, while the market has continued to hit new records
Take July 2021’s CAPE ratio of 38, for example. According to a 2020 analysis by Michael Finke, a professor of wealth management at The American College of Financial Services, that level would imply annualized returns over the next decade of roughly 1%-2%
Five years on, the S&P 500 is up 73%, making for average annual returns of over 14% since then. A monumental market bust may eventually put that average down to 1%-2%, but it’s an apocalyptic outcome that’s a big unknown, and sitting on the sidelines in the meantime would be costly
Fidelity research bears out this point. In a 2024 report, the firm showed that if stocks did poorly over a 10-year period that started with a high CAPE ratio, it was likely because a crisis like World War II or the Great Recession sank the market
Plus, unless you’re exactly 10 years out from retirement or needing your money, you probably don’t have to worry anyway, and compounding dividends help make up for any lackluster period in returns
Here are a couple of other points to consider:
- The metric is too hung up on the past. Since the CAPE ratio measures current stock prices against a rolling 10-year average of earnings, it can miss some important developments in the meantime. Nvidia is a prime example. AI demand has made the company much more valuable over the last four years, so why would investors compare its current prices to a rolling 10-year average of earnings when AI wasn’t in the market Zeitgeist before 2022?
Valuations may behave differently than in the past. Back in June, I spoke with Ben Snider, Goldman Sachs’ chief US equity strategist, who said that he sees 7% annualized returns for the S&P 500 over the next decade despite current CAPE levels implying negative returns
That’s because he sees valuations staying higher for longer. He cited steadily rising profit margins over the last few decades, going from 7% in 2000 to around 13% today. “It doesn’t seem very likely that those will return to their long-term averages, and therefore, the assumption that valuation multiples should return to their long-term averages does not seem like a very compelling argument,” Snider said
