High Stock Values and the CAPE

The cyclically adjusted price-earnings ratio (CAPE) should not be a focus around current equity price levels, according to a recent Bloomberg article.

The CAPE now stands at 30, the article says, and was higher in only 59 months since 1881. “Investors are understandably concerned if it’s correct to expect the market to revert to a CAPE of about 24 over the next five years”–simple regression analysis shows that it takes an average of five years for the CAPE to revert halfway)–sending equities falling by about 22 percent, assuming earnings stay constant. “No wonder,” the article argues, “so many are waiting for a stock market correction before putting more of their savings to work.”

While there is evidence that the CAPE is in the process of mean-reverting, some of this is a result of “reversion-to-the-mean bias,” the article says. This means that even random events can appear to be mean-reverting “if the observer wrongly assumes that the recent level is the true mean.” By looking at historical CAPE relative to the current mean calculation, we are falling victim to such a bias.

“History and common sense tell us that paying a higher earnings multiple for equities lowers the return one should expect to earn. History, however, is not telling us that a mean reversion of the CAPE is likely to deliver a hit, or a windfall, to equity returns.”