The stock market is expensive.
No doubt about that.
But does that matter? And does the S&P 500's price-to-earnings ratio of 21 times mean the stock market is going to crash tomorrow?
Another valuation favorite: Currently the S&P 500 Index has a CAPE Ratio of 28.26. That measure is the cyclically adjusted price-to-earnings ratio, commonly known as the Shiller P/E. It's calculated by dividing price by the average of ten years of earnings (moving average) and adjusting for inflation.
It's true. Bull markets are hard to come by with a CAPE ratio this high. As Hedgeye Senior Macro analyst Darius Dale points out in today's Early Look about CAPE at 28.26:
"That’s in the 96th percentile of all readings (dating back to January 1881). If you concentrate on the trailing 30-year time period – which is arguably far more relevant than readings 100+ years ago – its 83rd percentile reading is still elevated, though not by as much."
Dale points out, over the past 30 years, "At this current extreme CAPE Ratio, the expected value of buying the S&P 500 today is +1.2%, -3.8% and -5.3% on a 1-year, 3-year and 5-year forward basis, respectively."
As the Chart of the Day below shows, these outcomes pale in comparison to lower decile (meaning CAPE Ratios in the bottom 10% of readings over the last 30-years). When the CAPE ratio is in the bottom 10%, forward 1-year, 3-year and 5-year returns are 4.2%, 9.2% and 17.2%.
This isn't a reason to sell stocks today. There is a significant amount of variability around these averages. Here's Dale again:
"Over the last 30 years, the average of the top ten 1-year forward returns of CAPE Ratio readings between the eighth and ninth decile is +31.1%. Can you afford to miss a +31% move to the upside in your benchmark?"
That's the point. As Hedgeye CEO Keith McCullough says, "Valuation is an opinion." It's the prevailing macro conditions that dictate what happens to both the P (price) and E (earnings). In short, expensive can always get more expensive and cheap can always get cheaper.
The question you should be asking yourself, is U.S. economic growth accelerating?
We think it is. That's why we told subscribers to buy stocks.
