The S&P 500 (SNPINDEX: ^GSPC) has long served as a barometer of investor sentiment. Among the tools used to assess the index’s valuation, the cyclically adjusted price-to-earnings (CAPE) ratio stands out for its ability to sift through short-term noise and reveal whether stocks are priced reasonably relative to their long-term earnings history. Understanding this metric helps explain both market extremes and the steps smart investors can take when prices climb sharply.
What does the CAPE ratio measure?
The CAPE ratio divides the current level of the S&P 500 by the average of inflation-adjusted earnings over the past 10 years. This approach removes the fluctuations that can distort ordinary price-to-earnings (P/E) ratios, which can appear artificially low during periods of abnormally high profits or artificially high after a single down year.
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A conventional P/E might appear “expensive” simply because earnings per share (EPS) have collapsed in a recession, even if stock prices have not fully adjusted. The CAPE ratio, by contrast, reflects a smoother picture of sustainable profitability across different economic cycles.
When the CAPE ratio begins to climb, it usually signals that stock prices are increasing at a faster rate relative to underlying earnings. While this can stem from investor optimism about future growth, it can also reflect mounting speculation or easy credit conditions. Over the long term, higher CAPE readings have been followed by more modest stock returns because frothy markets leave less room for further multiple expansion and more room for eventual compression when reality sets in.
The current environment in the technology sector echoes the dot-com bubble
Historical annual averages show that the CAPE ratio reached or surpassed a level of 40 for consecutive years only once: in 1999 and 2000, when it reached 42.1 and 41.7. These readings occurred during the peak of dot-com euphoria.
At that time, investors were pouring capital into internet start-ups and established technology companies alike, hoping that the emerging digital economy would generate limitless growth. As a result, many companies commanded stretched valuations despite minimal revenue traction and nonexistent profits. The broader market’s valuation expanded dramatically as enthusiasm outpaced concrete fundamentals.
