The cyclically adjusted price-to-earnings (CAPE) ratio has now closed above 40 for three months running. In more than a century of stock market data, that has happened exactly one other time: the dot-com bubble that eventually saw the S&P 500 (SNPINDEX: ^GSPC) lose nearly 50% of its value from March 2000 to October 2002.
So, should you be worried?
Missed Nvidia in 2009? This Rare Signal Is Flashing Again. In 2009, a “Double Down” signal flashed for a little-known chipmaker called Nvidia. For the first time in years, that same “Total Conviction” signal is flashing for a company 1/100th the size of Nvidia. Continue »
What the CAPE ratio tells us about market valuations
The CAPE ratio is basically a smoothed-out version of the ordinary price-to-earnings ratio (P/E), in which the price of a stock — or the entire market — is divided by its earnings per share (EPS). The difference is that the CAPE ratio takes the level of the S&P 500 and divides it by the average of its inflation-adjusted earnings over the previous 10 years.
That 10-year average is critical. A single bad year or one blowout quarter can send a regular P/E ratio all over the place, but the decade-long time frame takes out the noise when measuring earnings growth over time.
Why three months above 40 echoes the dot-com bubble
While the CAPE reaching such heights is concerning in and of itself, the three-months-in-a-row part is particularly so. It really drives home just how expensive the market is, and it makes the parallel to 1999 more stark.
Back then, the S&P 500 had roughly tripled over five years on enthusiasm for the internet, which investors believed would change the world. It did, but not before the bottom fell out. The market got ahead of the technology’s profitability and paid the price.
This belief that a new technology made it “different this time” led investors to ignore the signs and pile into companies with wild valuations just because they had “.com” at the end of their name.
Why this time is actually different
Now, while this obviously seems to rhyme with today, there’s a genuine argument that this time is materially different.
The dot-com highs were built on companies that were, in a lot of cases, barely companies at all, many with no profits — some without even revenue to speak of.
Today’s market is dominated by tech giants that make enormous amounts of money. Microsoft, Nvidia, Alphabet, and Amazon have the balance sheets and the income statements to justify a good chunk of what investors are paying.
