What Shiller’s Cyclically Adjusted Ratio Tells Us About 2024

In my usual analysis, I typically delve into technical indicators, sentiment gauges, or seasonal patterns. As options traders, we usually don't pay much attention to the S&P 500 Index's (SPX) price-earnings (P/E) ratio. However, this week, I'm shifting gears to explore it. Even for traders focused on shorter timeframes, considering certain macro factors can prove beneficial. It might offer insights for longer-term strategies, aid in risk management, or serve as a sentiment indicator. Specifically, I've delved into data on the Shiller S&P 500 P/E Ratio, also known as the CAPE ratio (Cyclically Adjusted Price-Earnings ratio). This metric calculates the P/E ratio of S&P 500 stocks while smoothing out earnings by examining the past 10 years and adjusting them for inflation.

I've analyzed monthly data dating back to 1928, and only a few instances have seen this ratio surpass 30. The first occurred in 1929, just before the Great Depression. The second was in 1997, reaching nearly 45 before the tech bubble crash in the early 2000's. It breached 30 again in 2017 and has hovered around that level since. Currently, it's trending upward, surpassing the 32.5 mark, the peak of this ratio just before the Great Depression. Next, I'll show what kind of returns stocks produced given the level of the CAPE Ratio.

S&P 500 Returns and the CAPE

The first table below shows the annualized returns of the S&P 500 going forward after CAPE Ratio readings above 25. For a benchmark, the S&P 500 averages about 8% per year since 1928. When the CAPE Ratio has been above 25, the one-year returns have slightly underperformed averaging about 6%. The longer-term returns are more concerning. Over the next five years, the S&P 500 averaged an annualized return of 3.4% and was positive barely half the time.

The second table shows S&P 500 returns after the CAPE Ratio reading was below 10. These low ratios have tended to lead to significant outperformance. The index gained an average of 18.5% over the next year, with 84% of the returns positive. Looking at the five-year returns, it averaged 13% on an annualized basis, with 100% of the returns positive. The CAPE Ratio has been a reliable long-term stock indicator.

For completeness, here is a table showing S&P 500 returns between these two extremes.

Implications of a CAPE Ratio

The chart below highlights the disparity of average annualized returns going forward based on the CAPE Ratio. If this tendency holds up, it could be a rough go for buy-and-hold investors over the next several years. If someone believes that’s the case, it might be a good reason to shorten time horizons…maybe get into options?

I’ve heard compelling arguments against a pessimistic outlook. In 1997, after the CAPE moved above 30, there were still a few years of substantial gains. Also, the ratio has been at an elevated level since 2017. The all-time average of the CAPE is around 19. It hasn’t been to this level since 2009. So, maybe some things have changed.

Those are famous last words but hear me out. Since Covid, especially, the Fed has created a huge amount of new money. Although the earnings in the denominator of the CAPE ratio is inflation-adjusted, price inflation has not kept pace with money creation. So, the new money might have a bigger impact on the price in the numerator depending on how much of that new money is directed into the market. If that’s the case, the CAPE ratio will settle around a higher normal reading for a prolonged period before price inflation catches up. So, there are reasons to be hopeful.