CAPE Ratio Warns That a Stock Market Crash Could Be Ahead
Valuations suggest that a stock market crash could be looming. Investors beware. Don’t get too complacent. Major losses could follow.
There are several valuation measures which say that a stock market crash could be ahead.
The first valuation ratio that investors need to look out for is the cyclically adjusted price-to-earnings (CAPE) ratio.
Think of this valuation ratio as a better price-to-earnings (P/E) ratio . The CAPE ratio is the P/E ratio adjusted for inflation and cyclicality.
At the time of this writing, the CAPE ratio stood at 32.11. (Source: “Online Data Robert Shiller,” Yale University, last accessed June 8, 2018.)
The number 32.11 by itself doesn’t really mean much; it’s important to look at it from a historical perspective.
The historical average of the CAPE ratio since 1881 is 16.87. So, one could say that the stock markets are currently trading 90% above their historical average.
This says “trouble ahead.”
Why? You see, the CAPE ratio is interesting; whenever it extends way above its historical average, a stock market crash soon follows.
Mind you, the last time the CAPE ratio was as high as it is now, we were in the midst of the tech bubble.
Market Cap to GDP Ratio Says “Immensely Overvalued”
The other stock market valuation that investors need to look for is the market cap to gross domestic product (GDP) ratio, also known as the “Buffet Indicator.” It essentially looks at how expensive the stock market is relative to the overall economy.
If this ratio is above 115%, it says that the stock market is immensely overvalued and that investors need to be very careful.
As it stands, the U.S. market cap to GDP ratio is 145%. (Source: “Buffett Indicator: Where Are We with Market Valuations?” Gurufocus, last accessed June 8, 2018.)
In simple words, the stock markets are currently standing well above the “immensely overvalued” level. Don’t ignore this.
Where’s the Stock Market Headed Next?
Dear reader, there’s one thing I have learned over the years: you have to take the fundamental data very seriously.
I can’t stress this enough: in the short term, valuations may not matter, but, in the long term, they dictate where the stock markets go.
I believe that the markets are standing at critical point. Valuations especially make a strong case for it.
Here’s how markets could play out: in the short term, we could see some upside.
Look at the chart below of the S&P 500 index.
Chart courtesy of StockCharts.com
The S&P 500 is breaking above a downtrend, and it has found a lot of support at its 200-day moving average. This says that bullish sentiment is prevailing.
But now, think long-term: since the bottom after the stock market crash of 2008–2009, key stock indices like the S&P 500 have soared over 300%. That’s just in nine years.
Let me ask this: could we see similar returns in the next nine years? By 2027, could the S&P 500 be trading at 8,304?
I will end with this: the returns in the next nine years may not be as great as they were in the previous nine years, and we could see a stock market crash sooner rather than later.
I make this bold statement in light of, not just extremely high valuations, but also due to massive changes in monetary policies across the globe, trade tensions between the U.S. and major economies, peaking U.S. economic data, and several other factors.