Why the CAPE Ratio Works

The cyclically-adjusted price-earnings ratio (CAPE), also known as the Shiller P-E ratio, attempts to smooth market valuations by using the 10-year P-E ratio instead of only current earnings. The problem for many investors is that the CAPE ratio has said U.S. stocks are highly overvalued for some time. Investors following CAPE missed a lot of profits. This article explains why the CAPE is working exactly as it is supposed to and that investors who have followed CAPE should be happy. A key to the success is to realize the investment world consists of more than stocks and cash.

This dynamic is no different in the investment markets. If markets are overvalued, is the safer bet that the markets will continue rising or offer sub-par returns? Statistically, the likely outcome is sub-par returns. Of course, that doesn’t mean the markets won’t continue climbing despite lofty valuations. And, of course, a bullish investor could make such a bet as did the tourist – and win. (And as we’ve demonstrated in the past, a cheap uptrending market is the best…but second best?  An expensive uptrending market…) But that doesn’t mean it’s a good wager.

Most investment research has shown that when people buy an expensive market, they have a higher chance of big drawdowns in their future.