CAPE Ratio Foretells Stock Market Crash
Valuations suggest a major stock market crash could be ahead sooner than later. Mark these words: Don’t get too complacent.
To see stock market valuations, it’s important for investors to pay attention to the cyclically adjusted price-to-earnings (CAPE) ratio. It’s essentially the U.S. stock market’s price-to-earnings (P/E) ratio adjusted for inflation and cyclicality. In other words, it’s a better measure than just the simple P/E ratio.
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Currently, the CAPE ratio stands at 30.49. (Source: “Online Data Robert Shiller,” Yale University, last accessed August 15, 2017.)
What does the 30.49 figure mean? You see, by itself, the number doesn’t make much sense. But, when you compare it to the historical averages and where it was a previous market top, it tells us something powerful.
Also Read: Stock Market Crash 2017? This Could Trigger a Stock Market Collapse
For starters, know that there have only been two times when this ratio has been this high—in 2000 and 1929. After both of these instances, a major stock market crash followed a few months later.
From a historical average perspective; the long-term monthly CAPE ratio of the U.S. stock market since 1881 is around 16.78. So, the ratio is currently 81.7% above its historical average.
Stock Market Capitalization-to-GDP Ratio Tells Losses Could Be Ahead
But, if this doesn’t convince you how overvalued the stock markets are and how we could be headed towards a stock market crash, then look at the stock market capitalization-to-GDP ratio.
Warren Buffett calls this ratio one of the best measures of stock market valuation.
If the stock market capitalization-to-GDP ratio stands below 100%, it is considered undervalued. Values below 50% suggest stock markets are severely undervalued.
In contrast, values above 100% suggest that the market is overvalued. A stock market capitalization-to-GDP ratio above 115% is considered to be significantly overvalued.
Also Read: Warren Buffett Indicator Predicts Stock Market Crash in 2017
With that said, the stock market capitalization-to-GDP ratio currently stands at 132.8%. (Source: “The Ratio of Total Market Cap to US GDP,” Gurufocus, last accessed August 15, 2017.)
If this doesn’t tell us that stock market valuations are extremely expensive, then what will?
Could Stock Market Crash in 2017?
Dear reader, if you listen to the mainstream, it will tell you all about how “this time it’s different,” and stocks are worth a buy no matter what.
I reiterate; don’t get too complacent. History is evident; when valuations are extremely high, a stock market crash usually follows. So buying stocks at those times doesn’t make sense at all.
But, also know this, prior to a major sell-off, there’s usually a ramp-up, where key stock indices move higher at a very quick pace. Thus, it wouldn’t be shocking to see the indices run up even more.
There are a few catalysts I am looking for.
Know that a stock market crash occurs when investor sentiment turns bearish. There’s still a lot of bullishness present. If there’s consistent selling on the back of heavy volume, for me, it would be an indicator that suggests losses could follow.
In the end, I repeat what I have said all along; the time to buy is when prices are low and no one wants to buy. Not when prices are extremely high, and bullish sentiment is prevalent.
