Is The Market About To Fall?

You can’t predict the market, or so the saying goes, but that has never stopped analysts from trying. Countless hours have been spent digging into quarterly reports and charting stock movements to forecast where individual stocks and the market as a whole is headed.

Yale professor of economics Robert Shiller has spent the larger part of his storied career examining the markets. The Nobel prize-winning economist published the book Irrational Exuberance in 2000, which predicted both the dot-com bubble and the looming real estate collapse of 2008.

Shiller was able to predict those events in part because of a measurement that he had created in 1996 which served as a yardstick for market valuation. The cyclically adjusted price-to-earnings (CAPE) ratio measures performance over the long haul, usually a period of ten years.

Also called the Shiller P/E ratio after its creator (although Shiller developed it in conjunction with economist John Campbell), the CAPE ratio has been applied retroactively. It successfully predicted stock market drops from the Great Depression through the tech struggles of 2022. Now, after a 2023 rally, the market has crossed the CAPE threshold again.

So does it bode ominously for the stock market?

What Does The CAPE Ratio Measure?

The CAPE Ratio is based on the price-to-earnings (P/E) ratio, which is a common equation used to measure whether a stock is over- or undervalued. But P/E ratios by their nature are short-term measurements. The earnings half of the equation is based on the most recent net income a company reported last quarter or year typically.

Thus, the P/E value will change after each earnings release, and it could fluctuate wildly if there are unforeseen events that affect earnings. The health scare a few years ago, for example, impacted so many companies’ bottom lines, and as a result, it made it difficult for analysts to determine valuations based on P/E values alone.

The CAPE ratio tries to put that volatility in perspective by zooming out. Looking at a longer time frame can deliver a clearer picture of performance, without being affected by the short-term spikes and drops of the market.

The CAPE ratio can be applied to a single stock in order to understand how a company has performed over time against its peers (or against its industry). When taking the overall market into account, the Shiller P/E is calculated by taking the market’s comprehensive share price and dividing It by the 10-year average earnings (that has been adjusted for inflation).

What Does The CAPE Ratio Say About Today’s Market?

After analyzing decades of data through the new lens of the CAPE ratio, Shiller and Campbell began to see a pattern emerging. When there’s a rally during a bull market that sends the overall CAPE value above 30, there has been a corresponding pullback.

For example, from mid-1997 to 2001 the dot.com rally sent the Shiller P/E to its highest-ever mark: 44.2. When that bubble burst, the S&P 500 was nearly cut in half.

That should be alarming because there are plenty of modern-day analysts who have likened the artificial intelligence (AI) boom to the early days of the internet.

Companies that are involved in AI in any way have seen their shares skyrocket over the past few years. The most impressive example is the 275% single-year explosion for Nvidia (NASDAQ: NVDA).

Nvidia has led the “Magnificent Seven” stocks to the forefront of investors’ minds (and portfolios). That optimism sent the market’s CAPE value inching toward the 30 threshold, and it crossed over in July. The stock market’s current Shiller P/E is 34.24, and every time it has crossed that mark there has been at least a 20% pullback.

What Are The Limitations Of The CAPE Ratio?

Going on that knowledge alone, it might be tempting to take a step back from stocks. But there are limitations to the predictive power of the Shiller P/E. The main limitation is that it’s calculated using past data, which is not always an indicator of future performance.

Just because the bubble burst after the dot.com frenzy doesn’t mean the AI boom will follow suit. Also, the CAPE ratio only tells us that the market will pull back, it does not tell us when. During the dot.com years, the market’s Shiller P/E was above 30 for nearly four years before it finally took a downturn.

There have also been criticisms of the formula because it relies on Generally Accepted Accounting Principles (GAAP) earnings figures, and the regulations for GAAP have changed over the years. Those changes set the CAPE ratio up to have pessimistic leanings when it comes to forecasting.

Are Stocks Still A Good Long-Term Investment?

So what the Shiller P/E essentially tells us is that the market is highly likely to pull back, but it could be weeks, months, or years from now. While a future bear market is inevitable, it isn’t likely to last for long. Since the 1940s, 75% of US recessions were over in less than a year.

Bull markets, on the other hand, have an average length of 3.8 years. That’s confirmation of the philosophy that stocks are an essential investment because the market has always rallied back and kept on its upward climb.

It’s also reinforcement for the buy-and-hold-forever strategy that has been a key principle for Warren Buffett, one of the world’s most successful traders.

Is The Market Due For A Drop?

The CAPE ratio has been around for nearly 30 years, and it’s been proven to be an accurate predictor of future pullbacks. The stock market has been above a 30 CAPE value for months now, causing fears that a downtrend is imminent.

The main reason behind the rise is AI. As tech companies report their earnings this year, they will be highly scrutinized to see how AI has affected their revenue. There could be a pullback if the AI impact takes longer to materialize.

At this point, however, the AI boom seems to be in full swing. Given the average length of a bull market, it could be years before the CAPE drop occurs. Even then, the market has always rewarded patient investors.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.