Valuations Are High – So What?

Posted on June 26, 2018 by Gemmer Asset

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For years market prognosticators have been saying that valuations are high.  And if you look at the data, it’s true.  The Cyclically Adjusted PE or CAPE Ratio (see definition here), a measure of valuation that is generally thought to be more stable than other relative valuation measures, has been above its historical average since August of 2009 (S&P 500).




Here is the same chart with two additional horizontal lines showing +/- two standard deviation bands around the average.  Only three times in the ratio’s history has the CAPE been above that top line: 1) prior to the great depression 2) at the peak of the 2000 tech bubble, and 3) today.




OK, we agree that valuations are high.  But so what?  Should high valuations change your investment strategy and if so, how?  Lets look at an extreme example – going to cash as soon as the CAPE Ratio crosses above that long-term average.  If you did that in early 1991 and stayed in cash through December of 1999, you’d have missed out on S&P 500 returns of +426%.  If you did the same thing in August of 2009 and still held cash today, you’d have missed out on a +231% gain.  Even after the CAPE ratio passed the +2 standard deviation mark in June of 1997, the S&P ran another +87%!  A short-term timing tool the CAPE is not…


Where the ratio can be useful is in coming up with long-term return expectations.  Research affiliates has done some great work in this area (see here).  The chart below shows what happens when you regress S&P 500 returns with the level of the CAPE Ratio over different time horizons.




Panel A shows a virtually non-existent correlation between CAPE levels and subsequent 1-year returns.  As the time horizons get longer, (Panel B= 5 years, Panel C= 10 years, Panel D= 20 years) the correlation gets much tighter.  What the charts are saying is that over long periods of time, a high CAPE Ratio today implies lower than ‘normal’ future returns.


This argument is not without its faults however.  The folks at AQR recently published a piece taking issue with the methodology used in assessing the CAPE – Subsequent Return relationship.  Their point is that to get enough 10 or 20 year time periods for the analysis to be statistically significant, you need to use overlapping periods which means those “independent” data points aren’t so independent.  The history of modern financial markets is simply too short to say with a high degree of certainty that a high CAPE Ratio equals low returns.  Intuitively it should work, but its tough to prove.


Bottom line is that high valuations by themselves don’t mean much.  They do have some level of value in creating long-term return expectations, but even that relationship is not set in stone.


So the next time someone tells you the sky is falling because the CAPE Ratio is high, don’t panic.



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