We’ve looked at Tobin’s Q and we’ve looked at Total Value of Equities as a Percentage of U.S. GNP (Warren Buffett’s favorite) and in this post I’ll cover another broad market valuation metric, Professor Robert Shiller’s 10 year Average Inflation-Adjusted P/E Ratio, also know as CAPE.
The chart below is courtesy of multpl.com.
The long-term mean CAPE as calculated by multpl.com using Prof. Robert Shiller’s data is 16.42. The CAPE currently stands at 21.03.
The first reaction is to declare the stock market overvalued but this would be inappropriate. Broad market valuation metrics are best used as a tool to measure potential returns. We need to see the relationship between various levels of CAPE and the annualized total real returns experienced.
This first chart below measures the ten year annualized total real returns experienced at different levels of CAPE. All data was pulled from Prof. Robert Shiller’s website.
The next chart highlights the 5 year annualized total real returns and CAPE. Again, all data was pulled from Prof. Shiller’s website.
The probability that total real returns will be below-average for the next 5-10 years is high. However, as seen in the 5 year chart, when the time frame used to measure returns is shortened the range of potential returns widen. If we’re trying to guess stock market returns over a 1-2 year period then a broad market valuation metric, like CAPE, is not an appropriate tool. Broad market valuation metrics like CAPE, Tobin’s Q, and Market Value of Equities as a Percentage of GNP are best used as a measurement of risk; the risk that the equity markets will experience below-average returns over the long-term.
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