I would pay particular attention to the Shiller P/E Ratio, which is a variation on the Cyclically Adjusted P/E or CAPE. This indicator is worth watching as it has historically correlated with long-term stock market returns. Today’s reading, in the mid 20s, suggests below average returns in coming years. A further advance would suggest a more serious problem. By way of comparison, the indicator reached a high of around 30 prior to the 1929 crash and was close to 45 in 2000.
Market Realist – The cyclically adjusted price-to-earnings ratio or the Shiller PE ratio is a valuation metric usually applied to broad equity market indices like the S&P 500 (SPY) and the Dow Jones industrial average index (DIA).
Robert Shiller defined it as the price of a share divided by the ten-year moving average of its earnings. Using the ten-year moving average helps in gaining a long-term perspective and accounting for inflation.
Market Realist – The graph above shows that the Shiller PE ratio for the S&P 500 (IVV) is currently hovering around 26.27x. The metric was hovering around 27.6x before the financial (XLF) crisis of 2008, 44.2x before the technology (XLK) bubble burst of 1999, and 32.3x before the 1929 crash.
The Shiller PE ratios are nowhere near the historical bubble burst levels. But if they continue to rise, they could be cause for concern.
Read on to the next part of this series to see how sentiment indicators can point to overvaluation.