Chart of the Week

ARE STOCKS PRICED FOR PERFECTION?

The US stock market has performed very strongly since it bottomed in late 2022, raising concerns it is now becoming overvalued.

So is all the good news priced in?

The chart below shows the S&P 500’s cyclically-adjusted price/earnings (CAPE) ratio going all the way back to the start of the 20^th century.

The CAPE ratio, otherwise known as the “Shiller P/E,” is widely regarded as a reliable gauge of valuation. It smooths out earnings trends over a decade, reducing the noise associated with the business cycle and other short-term factors.

Historically it has helped to signal extremes in over and undervaluation. Notably the bull market peaks in 1929 and 1999. And the secular bear market low in the early 1990s.

Typically, whenever the ratio trends above 30x (like it is now), it suggests US stocks are becoming richly valued.

That’s the bad news and reason for caution, particularly given how dominant US stocks have been in driving equity returns over the past few years.

The good news is the CAPE ratio, like most valuation metrics, is a lousy timing tool. Simply put, the US stock market is prone to staying in overvalued territory for prolonged periods, especially in the post-2008 crisis era, which has seen Central Bank liquidity support distort prior valuation “rules”.

In conclusion, investors should not ignore the fact US equities appear overvalued, but that doesn’t mean the end of the bull market is imminent.