CAPE Ratio Says Stock Market Crash Could Be Ahead
Truth be told, there’s a lot of optimism and borderline euphoria out there. Don’t get too complacent in the midst of all this. It foretells a stock market crash ahead.
How can you tell that there’s optimism and euphoria? Investors are paying top dollar for stocks and completely disregarding the fundamentals.
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Consider the basic valuations.
Look at the cyclically adjusted price-to-earnings (CAPE) ratio of the stock market. It’s the price-to-earnings (P/E) ratio adjusted for inflation and cyclicality. The CAPE ratio gives us a better idea of how investors are valuing the stock market than just the plain vanilla P/E ratio.
At the time of this writing, the ratio stood at 33.18. (Source: “Online Data Robert Shiller,” Yale University, last accessed September 18, 2018.)
What does this number actually mean? The number 33.18 doesn’t mean much by itself. It’s important to look at it from various perspectives though.
The long-term average of the CAPE ratio is around 16.9. So, one could say that the stock market is trading at 96.3% above its historical average.
With this, know one thing: the markets tend to come back to this long-term average at times. If we see a mean-reversion sort of event, there could be a massive stock market crash.
But this isn’t all.
The last time the CAPE ratio was this high was in June 2001. This was just before the sell-off that took key stock indices like the Dow Jones Industrial Average and S&P 500 much lower.
Let’s take it up a notch; there has only been one time when the ratio was higher than it has been this year, and it was in the midst of the tech bubble. The ratio today is even higher than it was in 1929 before the Great Crash.
Where Do We Go From Here?
Dear reader, the mainstream media will have you convinced that all is well and that there’s nothing much you need to worry about. You will hear a lot of “this time it’s different!” rhetoric. And if you even mention words like “stock market crash,” you will be ridiculed.
Valuations don’t seem to matter much these days. It’s scary, to say the very least.
I want you to do this one thing: go to any financial newspaper or TV channel and see if they are running any bearish story at all on their front page. It’s highly unlikely that they are running anything negative about the stock market.
When I see that valuations are extremely high and no one is talking about it, I am concerned.
I have said it before and I will say it again: in the next few years, stock markets could look completely different. I am seriously not convinced that stocks will offer solid returns in the coming years.
Call me a skeptic, naysayer, perma-bear, or whatever, but the stock market may not show as stellar returns in the next two to three years as it did in the past two to three years. Expect a sizable stock market crash during this time as well.
To reiterate, capital preservation could be very important for long-term investors. If there’s a stock market crash sooner rather than later, it will be faster than last time. Sell-offs tend to be very quick and rallies tend to be slow.
