Monitoring The Cape Ratio: Are Stocks Overvalued or Will the Bull Run Continue?
Amid a historic rebound, the S&P 500 has hit another all-time high after flirting with correction territory just three months ago in March.
With the S&P 500 dropping more than 10% in March from its previous high of 6,144 in February, the benchmark has now rebounded and hit a new peak of over 6,180 on Friday.
Such a fast recoup in the broader market is unprecedented and can sometimes take years. That said, it's certainly a worthy topic of whether stocks are overvalued or if there is indeed a clear path for a Bull market to continue.
To do so, let's take a look at the Cape ratio, also known as the Shiller P/E ratio, and review the bullish sentiment that's lifting markets. Notably, the Cape ratio is used to calculate the price of the stock market or individual stocks relative to their average inflation-adjusted earnings over the last 10 years.
Keeping this in mind, the Cape ratio smooths out fluctuations caused by economic cycles, providing a clearer view of whether stocks are overvalued or undervalued based on their historical average.
Preluding the market correction earlier in the year, many analysts, including famed billionaire Jeffrey Gundlach, had called for a market recalibration based on the Cape ratio's reading of 38X earnings on the benchmark S&P 500, the second-highest level ever.
This Clinically Adjusted Price-to-Earnings Ratio (CAPE) has roots that date back to 1934, when David Dodd and Warren Buffett's mentor Benjamin Graham proposed smoothing out earnings over multiple years in their investment book 'Security Analysis', which provided a foundational idea behind CAPE.
Retroactively calculating historical earnings data for the U.S. stock market back to 1881, the Cape ratio was formally introduced by economists Robert Shiller and John Y. Campbell in 1988. Furthermore, the Cape ratio gained notoriety in the late 1990s and early 2000s, thanks to Shiller's warning of the dot-com bubble.
Following the broader market's most recent and historical rebound, the Cape ratio on the S&P 500 is currently at 36X, which is once again well above its historical average of around 16-17X.
Image Source: YCHARTS
Despite the Cape ratio indicating stocks are overvalued, a clearer path to global economic growth has been established with the U.S. officially reaching a framework trade deal agreement with China on Friday. President Trump's 10% baseline tariff on most countries is set to expire on July 8, but has eased concerns that rattled the stock market, providing a 90-day pause on higher imposed country-specific tariffs. While this deadline is just a few weeks away, Treasury Secretary Scott Bessent has advised that most trade deals should be done by Labor Day (Monday, September 1st).
Allowing more time for negotiations, the U.S. has come to a trade agreement with the U.K. as well and is in talks with other major trading partners, including the E.U., India, and Japan. Optimistically, May's jobs report and inflation data added fuel to the market rebound earlier in the month after coming in better than economists' expectations. Meanwhile, reports of an Israel-Iran truce were able to sustain this optimism, although it's noteworthy that President Trump has just gone on the record and said he is terminating trade talks with Canada at the time of this writing.
While overly bullish market sentiment can sometimes be questioned as a conundrum, investors should know that this usually preludes to higher corporate earnings, the general principle that manifests in a higher stock market.
Over the last decade, the earnings from the companies in the S&P 500 have grown by over 9% annually, with the index up a bullish +200% during this period.
Image Source: Zacks Investment Research
Considering the stock market needs higher EPS figures to ease the Cape ratio's overhyped reading, it's noteworthy that Zacks director Sheraz Mian has pointed out that S&P 500 earnings for the second quarter are currently expected to be up +4.9% from the same period last year on +3.9% higher revenues.
However, Mian also points out that while negative revisions to Q2 estimates have stabilized in recent weeks, tariff uncertainty has caused estimates for the period to be under significant pressure relative to other recent periods.
Inherently, for the bull run to continue, a relatively strong Q2 earnings season and better-than-expected corporate guidance will be crucial, with the Cape ratio at a very high 36X. This may certainly be the case with the S&P 500 already hitting a new all-time peak after rebounding +10% in just three months.
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This article originally published on Zacks Investment Research (zacks.com).
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