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Jerome Powell’s comments on high US equity valuations led to a dip in the S&P 500 this week.
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The Shiller CAPE ratio and other metrics show the Fed chief is correct that valuations are high.
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Yet, rich valuations may not mean pain ahead for investors if earnings remain strong.
Federal Reserve Chair Jerome Powell caught investors’ attention on Tuesday when he said that the US equity market is “fairly highly valued.”
While it’s never nice to hear the Fed chair speak in less-than-bullish tones, Powell’s observation shouldn’t have come as a surprise to investors. After all, he’s right — at least for the most part.
By many measures, the stock market broadly is historically expensive. Take it from Bank of America, which pointed out this week that 19 out of 20 valuation metrics it tracks show the market is historically expensive, with four of the gauges at all-time highs.
Let’s dive into a few measures that show stocks are pricey.
One of the most cited and followed metrics is the Shiller CAPE ratio, which measures the S&P 500’s current price compared to a rolling 10-year average of earnings. This week, it hit its highest level since the peak of the dot-com bubble.
High stock valuations can be a foreboding signal for long-term returns. The Shiller CAPE ratio in particular has a high correlation with 10-year forward returns. When valuations are elevated, future earnings upside is already priced in, usually resulting in poor subsequent performance for share prices.
The Shiller CAPE ratio isn’t perfect, though. One of its limitations is that, because it measures a 10-year rolling average of earnings, it can be slow to reflect current conditions and therefore may not be as great a predictor of future returns as is believed, said Yale economist William Goetzmann.
“Every observation is just moving forward one year, one month, so basically you’ve got a lot of correlation between one observation and the next one,” Goetzmann told Business Insider earlier this month. “It’s very difficult to be confident about the results of that analysis when you have overlapping returns of 10 years or even five years.”
Tom Essaye, the founder of Sevens Report Research, also pointed out that while the Shiller PE is an impressive metric, it’s not forward-looking.
“When you’re in the market, it doesn’t matter what it’s done in the past, it only matters what it will do in the future,” Essaye told BI. “That’s why people on the street use forward PE exclusively.”
