With stocks hitting all-time highs (at least twice this year), there is no shortage of financial pundits predicting the end of this now-longest-in-history market run. In addition to the length of this bull market, pundits often cite lofty stock valuations as a concern.

They have a point; stocks are expensive. A widely-accepted measure of valuations is the cyclically-adjusted price to earnings ratio (CAPE ratio for short), and by that measure stocks are more expensive than 90% of their history!

First, what is the CAPE ratio? Most folks are familiar with the concept of the price-to-earnings ratio (P/E for short). The P/E ratio is simply the price per share of a company divided by the earnings per share of the company. You can think of the P/E ratio much more simply: it is the price investors are willing to pay for every $1 of profit. So, if a company makes $2 per share, and the price of that company is $50, then you can infer that investors are paying $25 for every $1 of profit.



That is why P/E is a useful tool for gauging value— all else equal, paying $25 for $1 is more expensive than paying $15 for $1. The CAPE ratio is similar to the traditional P/E, but it adjusts for inflation and looks at a longer period of earnings. As the chart above shows, with a current CAPE ratio of 33 the S&P 500 has moved firmly into expensive territory. Indeed, across the whole of the 2002 to 2007 expansion, markets stayed firmly below that figure—tracking around the more appropriate 25 level.

Now, when my mind hears “expensive” it immediately equates that to “sell,” or at the very least “don’t buy.” As we learned in the 1990s, however, stocks can stay expensive for a very long period of time. It was June of 1996 when stock valuations first moved above 30. They stayed above that level (even moving above 40) for another six years. And that wasn’t a paltry six years, either, those were legendary boom times.

So, what information do valuations give you about future returns? In the chart below, we plot the CAPE ratio against the S&P 500 return 1 year, 5 years, 10 years, and 20 years later. As you can see, there is very little relationship between valuations and 1-year returns, especially in the 30 range. As you move out to 5 and 10 year horizons, however, the relationship tends to get a bit firmer. This makes intuitive sense as lofty valuations tend to occur near the end of the economic cycle. Returns, then, get reduced through a subsequent recession.



In summary, valuations do not carry much information about returns over the coming year. Of more help to investors is identifying and allocating defensively ahead of recessionary environments. So, don’t be too worried about buying expensive stocks. They may stay that way for a while.

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