\u201cBuy low, sell high\u201d may be the most renowned catchphrase in all of finance, and rightfully so. It\u2019s a beautiful summation of a sound investment strategy, an adage to help maintain discipline through tough times and exceptional times alike. Even those with little to no investment experience are likely familiar with the phrase. It is only natural, then, that investors may start to wonder if now is a good time to carry out the latter half of that motto. We have, after all, experienced a record-breaking bull market, and with the S&P 500 and the TSX Composite indices both hitting all-time highs this year, one could conclude that the markets have become \u201cexpensive\u201d in recent years. But how does one ascertain whether the stock market as a whole has become pricey? How can we tell if the S&P 500 should be at a level of 2,800, or 5,600?<\/p>\n
To answer these questions, we first need to understand the investment concept of multiples. Multiples\u00a0are a metric that compares a company\u2019s operations to its stock price, and one of the most intuitive multiples out there is the forward price-to-earnings, or forward P\/E multiple, which divides a stock\u2019s price by the company\u2019s expected<\/em> earnings-per-share over the next 12 months. Naturally using expected earnings means that we need to lean on estimates, however because many believe that the markets are forward-looking (i.e. they trade stocks based on their future, not their past), it is still a useful measure, as it show how much an investor is paying for a dollar of expected earnings, A.K.A. how expensive<\/em> the stock\u2019s fundamentals are, and by comparing the ratio to a historical average, we can understand whether investors are paying more or less for a dollar of profit than is typical.<\/em><\/p>\n Multiples are commonly used for individual stock positions; however, we can use them to gauge the markets as a whole, too. By using a representative U.S. stock index such as the S&P 500, which contains 500 of the largest U.S. stocks by market capitalization, we can aggregate all the stock prices and earning-per-shares of the index\u2019s constituents and calculate a forward P\/E multiple for the index. Doing this shows that, as of September 5th<\/sup>, the S&P 500 had a forward P\/E multiple of around 16.7x, which is higher than its long-term average of 14.3x.<\/p>\n So, we have our evidence that the markets are expensive, right? Well, not quite. This measure fails to consider inflation, a factor that would naturally alter P\/E over time if not accounted for properly. It is also a widely held belief that the economy follows a cycle of booms and busts, so a higher P\/E may simply reflect the near-term influences of this omnipotent cycle.<\/p>\n Luckily, we can accommodate for these factors by using what\u2019s known as the Cyclically Adjusted P\/E ratio (CAPE), also known as the Shiller P\/E, named after its creator, American economist Robert Shiller. The CAPE uses inflation-adjusted earnings and averages them over 10 years to \u201csmooth out\u201d the effect of the business cycle on earnings, thereby allowing us to better observe the underlying movement in the multiple. Using this new measurement, one would assume we\u2019d come to a more tepid reading of the market\u2019s price level, but to the contrary, the CAPE (as of Tuesday) stands at a whopping 33.0x, almost double its long-term average of 16.6x.<\/p>\n Does that mean markets are overvalued? Should we be concerned about this heightened multiple level? Perhaps, but unfortunately, interpreting the CAPE is not as straightforward as one would hope; Robert Shiller himself explained back in 2017 that \u201cthere is no clear message\u201d from the signals given off by the measure.<\/p>\n Don\u2019t get me wrong, the CAPE reading provides some valuable insight into the pricing of the market, but it does have important limitations. Firstly, while the CAPE measure does consider 10 years of data, it does not take into account the long-term growth expectations of earnings, which may justify heightened valuations. Secondly, we need to remember that the market capitalization-weighted S&P 500 is far from a perfect gauge of the U.S. market, which has over 3,600 exchange-traded domestic companies alone; unless you invest solely in S&P 500 index funds, the CAPE measure won\u2019t accurately represent the valuation of your holdings.<\/p>\n But most importantly, there\u2019s actually a more idiosyncratic issue with our current CAPE reading. Remember that the CAPE ratio averages earnings over the last 10 years, and Saturday September 15th just so happens to have been the 10-year anniversary of the Lehman Brothers\u2019 bankruptcy, an event considered to be the height of the 2008 financial crisis. Company earnings were exceptionally compressed during 2008 and 2009, meaning that the 10-year earnings average for our CAPE measure is skewed downwards. One could argue that data from 2008-2009 is abnormal and too severe to be included in our average measurement (if you recall your high school statistics course, this time period would be classified as an outlier), and once we\u2019ve shifted our moving average forward another few years, holding all else constant we can surely expect our CAPE measure to normalize downwards.<\/p>\n There\u2019s no doubt that the markets have seen an impressive rally, and stocks may certainly be more expensive than is typical, however there\u2019s no tell-tale sign that we\u2019ve hit a ceiling in stock prices. That\u2019s not to say a market correction won\u2019t happen; as with most things in investments it is impossible to know what\u2019s waiting around the corner, but we can prepare for the worst without selling high and exiting the market. As Robert Shiller said himself, \u201clong-term investors shouldn\u2019t be alarmed and shouldn\u2019t avoid stocks altogether.\u201d<\/p>","protected":false},"excerpt":{"rendered":" \u201cBuy low, sell high\u201d may be the most renowned catchphrase in all of finance, and rightfully so. It\u2019s a beautiful summation of a sound investment strategy, an adage to help maintain discipline through tough times and exceptional times alike. Even those with little to no investment experience are likely familiar [\u2026]<\/span><\/p>\n","protected":false},"author":11,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"image","meta":{"footnotes":""},"categories":[7,9],"tags":[],"class_list":["post-1622","post","type-post","status-publish","format-image","hentry","category-investing","category-investors-mindset","post_format-post-format-image"],"yoast_head":"\n