Not all heroes wear CAPEs

Speculative fervour

It's sure felt like there's been a lot of speculative activity over the past couple of years, with the Bitcoin boom, a raft of borderline certifiable valuations for growth and tech stocks, plus a wide range of other soft indicators of a market nearing its peak (such as suspiciously flimsy-looking floats, and so on). 

But how to measure this in a single number, or a ratio?

Not so easy to do!

The traditional price-earnings (PE) ratio is sort of useful, but also has significant limitations, not least because the 'E' parts of the ratio (earnings) aren't exactly clear cut. 

As someone that spent way too much time in my professional career writing annual reports I'm painfully away of how easily profit figures can be manipulated, especially when market and stakeholder expectations are high.

Looking forward

And then there's the not-so-small matter of whether to use trailing or forward PEs. 

You can find historic earnings by looking at a company's most recent financials, but that's not much use for understanding the next year's outlook or for projecting next year's bottom line. 

Perhaps most critically of all, a PE ratio tells you nothing about the prospects for growth.

So a low PE might be a good signal...but it might not.

Sometimes analysts look at cyclically adjusted PE (CAPE) ratios as a popular proxy for calculating whether a market is overvalued. 

Adjusting for cycles

Now there's no foolproof way to measure whether a market is cheap or expensive, but one simple thing you can do is run a smoothed 10-year real earnings per share chart to iron out the bumps in company profits (which might well prove to be worse when the clouds form and the outlook takes a downward turn).

Plotted below is the Shiller PE ratio as at July 2019, which produces a far smoother chart than simply looking at current S&P 500 PE ratios for the US market. 

And the ratio has been running at over 30 lately. 

To put that in perspective, that's about the same level it was at just before the Black Tuesday Wall Street Crash and the ensuing Great Depression.

The Shiller PE ratio has been higher than this before, once (during the tech bubble).

And it's also crashed plenty of times before from much lower levels (Black Monday, global financial crisis, etc.).

Source: Shiller

Look out below.

This time...different?

Now you might argue that valuations have been pushed higher by low interest rates, quantitative easing, or other factors specific to this cycle, such as the strength of some technology companies.  

You might say that.

From looking at these figures I'd say that over the best part of a century-and-a-half such a level has never before been sustained. 

It doesn't so much matter what the specific grain of sand is that tips the scales, eventually something almost certainly will.

And if the US takes a tumble - which history says it will - Australia probably will follow suit too (although at least our stock market is arguably not so fully priced).

Dry powder

Now naturally I don't know anything about your situation, so there's no advice here.

But here's what I'm doing: 

(i) keeping a substantial sum of money in cash (actually in a mortgage offset account) as dry powder for when better opportunities come around; and

(ii) investing in some global ETFs in emerging and other markets where valuations have already plunged. 

Full disclosure: I am still invested in Aussie shares, but I also have some dry powder at the ready. 

I'm not suggesting it's a bad time to be invested in shares or anything like that - it depends on your age, your circumstances, and so on - just to be mindful of the cycle and to be clear about your strategy (and stick to it).