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CAPE fear shows stocks are dear

By Dr. Don Taylor · Bankrate.com
Monday, June 30, 2014
Posted: 6 am ET

Yale professor and Nobel laureate Robert Shiller was in the news twice last week: once for the monthly release of the S&P/Case-Shiller Home Price Index, which tracks U.S. residential real estate prices, both nationally and in 20 metropolitan markets, and also for his discussion about the CAPE index showing stock valuations at a level last seen in 2007, 1999 and 1929.

CAPE is the acronym for the Cyclically Adjusted Price Earnings Ratio. It measures the market's price/earnings ratio based on the average inflation-adjusted earnings from the past ten years.

Time to worry?

Not everyone agrees that the CAPE index is relevant in today's market because of the low interest rate environment. Even Professor Shiller makes the point that the money market and bond market returns in the current environment aren't very attractive, keeping people in stocks. He also doesn't suggest that investors use the CAPE index as a market timing tool. That said, he could see investors lightening up on their U.S. stock allocations, and possibly adding to international equity holdings. The graph below shows the history of the CAPE ratio back to 1881. The CAPE ratio is currently close to 26, but its historical average is about 17, and an index reading of 20 is considered a fairly valued market.

cape-index-reveals-high-stock-valuations

Individual investors by and large are lousy market timers. They tend to panic and sell at market bottoms, and get swept up in rising markets, buying in at the highs. Buying high and selling low isn't going to make you any money. But if you've been postponing rebalancing your portfolio because you've been enjoying the market's ride up since the recent crash, then it may be a good time to review your asset allocations and decide whether it's time to adjust your holdings.

There's an old adage in the market: No one rings a bell at the top (or bottom) of the market. The CAPE index has, however, been a bellwether in signaling that stock valuations are high.

What do you think? Are we at (or near) a market top for the U.S. stock market?

Read more on the topic: Time to rebalance investment portfolio?

Follow me on Twitter: @drdonsays.

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2 Comments
Tomaz Gonzales
August 30, 2014 at 7:12 pm

Dear Don,

why don't you draw the 100 divided by interest rate? In other words the price to earning of 10Yr binds. If you have above 10% interest rates, then a P/E of 10 is dangerous (it didn't get above 10 in the early 1970s). If you expect interest rates of greater then 4% next year 2015, would the PE of 25 be a problem? I think it would slow down the stock markets unless the earnings fall due to the credit costs.

Tomaz

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