Attention Investors: Is the CAPE Ratio Screaming Danger? Find Out Now!

As Robert Shiller’s cyclically adjusted price-to-earnings ratio (CAPE) climbs to unparalleled heights, the burning question on every investor’s mind is: should the current CAPE levels be a cause for concern?

1. The Track Record of CAPE:
   • Investment experts acknowledge that while CAPE has historically been a reliable indicator of equity market returns, it falls short as a market-timing tool. The data explored below sheds light on this peculiar phenomenon.

• Over the course of its history since 1900, CAPE has witnessed a pattern of ups and downs, demonstrating a cyclical trend of surges followed by contractions. The traditional belief that high CAPE periods precede low CAPE periods dominated the scene for many years.

1. Assessing the Relationship:
   • The correlation between CAPE values and future equity market returns reveals a striking negative association. In a graphical representation, the downward slope in Figure 2 vividly illustrates this negative correlation (correlation coefficient = -0.7). Although the connection weakens over 20-year periods, the trend remains negatively linked.
2. Questioning the Norm:
   • Could the prevailing narrative take a different turn this time around? The pivotal question centers on the stability of CAPE in a time-series context. Insights drawn from a comprehensive analysis urge us to reexamine CAPE’s predictability, as explored in the Journal of Portfolio Management.
3. Unveiling the Break:
   • Delving into the evolution of CAPE, particularly in the 1990s, raises some compelling points. CAPE’s average value skyrocketed post-1990, drifting astray from its modest mean value of 14.1 established earlier. At the current CAPE index of 34, we stand on the cusp of historical highs.
4. Detecting the Shift:
   • A dynamic analysis using the Quandt Likelihood Ratio (QLR) test pinpoints a possible break in CAPE dynamics in August 1991, a tangible shift witnessed since visual evidence indicates a divergence.

Concluding Remarks:
As investors grapple with the uncertainty surrounding CAPE’s stability and its implications for future market returns, the need for vigilance and adaptability in investment strategies becomes paramount. The evolving landscape of the financial markets demands a nuanced understanding of indicators like CAPE to navigate the stormy waters ahead. So, Should you worry that CAPE is high? That depends on whether you think CAPE will change again.