The stock market is already quite expensive. That is evident when you compare current stock valuations with those from previous eras.
But it is also true that stock prices are fairly reasonable right now.
That seemingly contradictory conclusion arises when you include other important factors: interest rates and inflation, which are both extremely low.
Examined on their own, stock valuations are at giddy levels, yet they are far more attractive when viewed side by side with bonds. That’s why it is so hard to determine whether the stock market is dangerously high or a relative bargain.
Consider that the S&P 500 index of U.S. stock prices has repeatedly set records over the past year, while a measure that I helped to create, the CAPE ratio for the S&P 500, is also at high levels.
John Campbell, now at Harvard University, and I defined CAPE in 1988. This is a bit technical, but please bear with me: The numerator is the stock price per share corrected for consumer price inflation, while the denominator is an average over the last 10 years of corporate reported earnings per share, also corrected for inflation.
Why go to the trouble of looking at the stock market with the CAPE ratio? Averaging earnings over 10 years smooths out year-to-year fluctuations and provides an earnings estimate that should be, for most companies, a better measure of long-term fundamental value. This 10-year average of real earnings is not quite as up to date as the latest earnings data, but it provides a more sober assessment of corporate earnings power.
A high CAPE ratio suggests that the market is overpriced, portending low subsequent returns, while a low CAPE suggests the opposite. Professor Campbell and I showed that the CAPE ratio allows us to forecast over a third of the variance of long-term returns on the stock market since 1881.
The CAPE ratio is 35.0 today, much lower than its highest level, 45.8, which was reached on March 24, 2000, at the peak of the millennium stock market boom. The market fell sharply soon after, and the CAPE has climbed much of the way back, reaching a cyclical high of 35.7 on Feb. 12. Its current range is the second highest since our data began in 1881.
Unequivocally, the market is expensive compared with past eras. This high pricing of stocks today is peculiar to the U.S. market, which has the highest CAPE ratio of 26 major countries, according to calculations by Barclays Bank. This disparity has been sustained despite the blows of the pandemic of 2020, and the civil unrest and occupation of the U.S. Capitol on Jan. 6.
Laurence Black at the Index Standard and Farouk Jivraj at Imperial College London and I came up with another measure. We call it the Excess CAPE Yield, or E.C.Y.
Put simply, the E.C.Y. tells us the premium an investor might expect by investing in equities over bonds. It is defined as the difference between the reciprocal (or the inverse) of CAPE — that is, 10-year average annual real earnings divided by real price — and the real long-term interest rate.