Robert Shiller’s closely followed “CAPE” ratio, which compares the S&P SPX, -0.30% to the average annual inflation-adjusted earnings of that index over the prior 10 years, has been signaling a top-heavy stock market for a while now.
See also: Shiller’s latest take on valuations.
But there’s a better way to gauge just how pricey equities have become, according to Meritocracy Capital’s Howard Ma.
While the CAPE ratio has proven to be a reliable predictor of long-term returns, it’s also been widely criticized, Ma explained. One reason is that it’s susceptible to outliers, like those abnormally weak earnings during the global financial crisis.
So Ma is offering what he sees as a more accurate tweak to the formula by using the median instead of the mean. He calls it the “CAPME” ratio and says it’s perhaps more useful because it is not influenced by the outliers in Shiller’s version.
As you can see by this chart, this metric also screams “overvalued” and “puts the U.S. stock market smack-dab at the heart of bubble territory”:
Obviously, different measurement, virtually the same result. It’s tough to get away from the idea that the market is getting a bit ripe.
“It has been argued lots that the high stock market valuation is justified by low interest rates,” Ma writes. “This argument does not work for me.” He explained that yields on 10-year U.S. bonds in early-1941 were lower than they are now, and that, despite those lower rates, the CAPME valuation ratio was also quite low.
“Furthermore, the amount of debt provided by stockbrokers used to fuel the current stock market cycle is at a record level,” he said. “This could prove problematic given bubbles driven by financial leverage are particularly dangerous.”