No single stock market forecasting model is infallible.
It’s an unsettling thought. But it’s true. And some of the most respected stock market experts would warn that even the most reliable and consistent models are capable of breaking down.
In his new monthly market commentary, Blackstone’s Byron Wien discusses how Robert Shiller’s CAPE ratio warnings are being ignored by market participants, who continue to push stock prices to record highs.
CAPE, or the cyclically-adjusted price-earnings ratio, is calculated by taking the S&P 500 and dividing it by the average of ten years worth of earnings. If the ratio is above the long-term average of around 16, the stock market is considered expensive. Currently, CAPE is at a very worrisome 26.3.
“It reminds me of the dividend discount model I developed at Morgan Stanley in the 1980s which related the level of the S&P 500 to the yield on the 10-year U.S. Treasury,” Wien said of CAPE. “The model worked well in the late 1980s and early 1990s and I thought it would carry me through to retirement. It was a sad day in the mid-1990s when I realised it was no longer relevant.“
Wien has one of the longest, most-notable careers on Wall Street. We’d argue that he’s maintained his own relevance by recognising when once-relevant models lost relevance.
But, how dare anyone suggest CAPE may no longer be relevant? Shiller won the Nobel Prize in economics for his work related to CAPE.
Believe it or not, Shiller would even warn you about CAPE.
“Things can go for 200 years and then change,” Shiller warned in an April 2012 interview with Money Magazine. “I even worry about the 10-year P/E — even that relationship could break down.”
We’re not suggesting that CAPE is now broken. We’re just noting that folks like Wien and Shiller will tell you that there’s a risk it could break. Indeed, anyone who’s stayed out of the market because CAPE is high has been missing out on some big market gains.