A single metric never tells the whole story of where the market is going. That said, one famous variant of the price-to-earnings ratio—a classic way to assess stock values—indicates the stock market is historically expensive. The variant is known as the "cyclically adjusted price-to-earnings ratio," or CAPE, and it shows the S&P 500 is currently pricier than before the Great Recession, as well as “Black Tuesday” in 1929, fueling speculation that another bubble is soon liable to burst.
The P/E ratio, perhaps the most basic and widely used relative metric in finance, can help investors determine whether a company’s stock is overvalued relative to competitors, the broader market or its own historical returns. The same calculation can be done for a benchmark index like the S&P, but there’s a problem.
“The ups and downs of the business cycle may give you a lot of noise than what the underlying earnings potential of the entire equity market will be,” said Bill Sterling, founder and global strategist at Boston-based GW&K Management.
In the 1990s, longtime Yale economics and finance professor Robert Shiller decided to minimize short-term volatility in corporate profits by using inflation-adjusted 10-year earnings data in his calculations. The metric became the foundation for Shiller’s argument that the dot-com frenzy would prove to be a bubble. The CAPE, also known as the Shiller P/E ratio, reached an all-time high in December 1999, just before his prediction bore out.
As the chart below shows, the adjusted P/E ratio has recently climbed well above its historical mean, as well at its average level since 1990. The message? Listen to the Nobel laureate's measure and sell.
View this interactive chart on Fortune.com
If only it were that simple. Executives at a range of investment firms told Fortune, however, that the CAPE's best days as a leading signal may be in the past. They said the metric’s commonly cited limitations, as well as structural changes to markets over time, have greatly undermined the measure’s usefulness.
For instance, since the early 1990s, the market has only been cheaper than its long-run average for a few months after the 2008 crash.
In November 2021, the measure peaked above 40. It was the CAPE's highest reading since October 2000, during the early days of the dot-com debacle.
The S&P has gained 21% since. Simply put, the Shiller P/E ratio has been ineffective, said Michael Green, portfolio manager and chief strategist at Simplify, an ETF manager that specializes in risk strategies.
“If you had paid attention to it,” he said, “you'd be out of business today.”
Why Robert Shiller's metric is not a holy grail
Even while admiring Shiller’s work, experts caution the CAPE falls short of capturing the market’s earnings potential. Chief among them is that the metric is, by nature, backward looking, said Eric Beyrich, an equity portfolio manager at Florida-based investment firm Sound Income Strategies.
“You're inflation-adjusting historical earnings,” he said of the CAPE, “and the market is pricing future earnings.”
Many also question comparing current and historical returns when a stock market that was once 30% railroads, as Sterling put it, is now highly concentrated in high-growth tech stocks. The rise of private equity, Beyrich said, has also greatly affected the constituency of the index. Developments like outsourcing, he added, have structurally pushed corporate profits higher.
Green, meanwhile, can provide many other explanations for why corporate profits will remain above their historical average, even in a recession. More fundamentally, however, he believes the rise of passive investing—including target-date funds common in 401k plans and so-called “quant funds” that use algorithms to trade off market signals—has changed how markets operate.
Green emphasized his research does not represent a consensus view. Still, there is wide agreement that investors can’t treat measures like the CAPE and other price-to-earnings ratios as a holy grail.
“They're discussed all the time because they're easily accessible,” Sterling said, “and they do have some informational content, but you shouldn't put too much weight on it.”
