Valuations Scream Trouble While Investors Shrug
Anthony Summers|August 22, 2023
It’s a simple question most investors don’t want to acknowledge… let alone answer.
Are stocks overvalued?
Ignoring this question will cost you.
But the answer isn’t where the mainstream would tell you to look.
Most folks know about the P/E ratio.
It’s the ratio of a stock’s price over its earnings per share. It’s an easy way to tell whether stocks are cheap or expensive.
Here’s the S&P 500’s historical P/E…
Over the past 150-plus years, the average P/E of the S&P 500 has been about 16.
Right now, it’s clocking in at about 25… or around 56% higher than average.
So it looks like we’ve gotten our answer. Stocks are overvalued. Plain and simple.
Oh, but we’re not quite done yet…
You see, while P/E is easy enough to understand, it’s not without its flaws. In fact, it oversimplifies the picture by not factoring in both inflation and changes in the business cycle.
Instead, investors should turn to Nobel laureate economist Robert Shiller’s cyclically adjusted P/E ratio, or CAPE ratio. It improves on P/E by using average inflation-adjusted earnings over a 10-year period.
Just like P/E, the CAPE ratio – now valued around 30 – is much higher than its historical average of 17.
But the CAPE ratio also says something more critical…
Stocks aren’t just overvalued. They’re extremely overvalued.
The CAPE ratio has been this high only 5% of the time.
That’s alarming… but few folks know it.
As I told you a couple of weeks ago, the connection between risk and reward is broken… and has been for quite some time now.
Too many retail traders and investors just don’t seem to care much about valuations anymore. It’s almost as though they can’t imagine a reason NOT to buy stocks.
It makes you wonder…
Given that so few care, do these extreme valuations really matter in the end?
Yes.
History tells us that there is a real price to pay for paying too much. And that cost comes in the form of much lower long-term returns.
That brings us back to the CAPE ratio…
Anytime it’s been 30 or higher… stocks have tended to underperform 10-year Treasurys over the subsequent decade.
Yes, you read that right…
Even Treasurys can beat stocks when investors overpay.
I’ll say it again. The CAPE ratio is already at 30.
I think you can do the math.
Anthony Summers
Anthony Summers is the Director of Strategic Trading for Manward Press and is a contributor to Manward Financial Digest, Manward Trading Tactics and Manward Letter. He is a former senior analyst for The Oxford Club, where he closely worked with some of our nation’s sharpest financial minds for nearly a decade. Anthony is a self-styled “conservatively aggressive trader” and has earned a reputation for developing unique trading strategies that focus on low-risk, high-return opportunities in both stock and options markets.
