Key Points
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The S&P 500’s cyclically adjusted price-to-earnings ratio ended Oct. 28 at 41.04, versus a long-term average of around 17.
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Its only other stretch above 40 lasted from January 1999 through September 2000.
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All 21 of these monthly readings were followed by a lower index five and 10 years later.
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The S&P 500 (SNPINDEX:^GSPC) has risen around 11% this year as I write. And by one valuation gauge with data going back to 1871, investors have rarely paid more for it.
That gauge is the cyclically adjusted price-to-earnings ratio (CAPE ratio), popularized by Nobel Prize-winning economist Robert Shiller. Rather than a year of profits, it divides the index’s price by its average earnings over the previous 10 years, adjusted for inflation, which is meant to smooth out both recessions and boom years.
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As the market closed Oct. 28, the ratio was 41.04. Its long-term average in monthly data is around 17.
Readings above 40 have been rare. The ratio has cleared that mark every month since May.
Until this year, it had done that only once — from January 1999 through September 2000, when it peaked at 44.19 in December 1999. Even in September 1929, right before that year’s crash, it was around 33.
How did the S&P 500 do after its only other run above 40? I used the index’s close on the first trading day of each of those 21 months. Next I measured the price change to the first trading day of the same month one, five, and 10 years later. (These numbers don’t count dividends.)
Image source: Getty Images.
One more good year
The short term depended a lot on when an investor started. Eleven of the 12 readings from 1999 were followed by gains over the next year, including a rise of around 18% from the Jan. 4, 1999, close. And the index climbed around 20% in 1999 alone, with the ratio above 40 the entire time.
Readings from 2000 went the other way. All nine were followed by a lower index a year later, with losses of around 3% to over 25%. The biggest came from the start of September 2000, the ratio’s last month above 40. The S&P 500 closed at 1,520.77 on Sept. 1, 2000, and a year later it was down to around 1,133.
That means anyone who sold the first time the ratio passed 40 would’ve missed a strong year.
Five and 10 years later, all 21 were lower
Over longer periods, the start date mattered far less. Five years later, every one of the 21 readings was followed by a lower S&P 500, down around 6% to 22%. Ten years later, all 21 were still lower, by about 18% to 43%.
From its close of 1,397.72 on Dec. 1, 1999 (the start of the month the ratio peaked), the index was around 6% lower a year later, about 15% lower after five years, and about 21% lower after 10.
Along the way, it sank to a low of 776.76 on Oct. 9, 2002 — around 49% below its Sept. 1, 2000, close. And from both those start dates, the index took over 12 years to get back above its starting level for good.
Reinvested dividends limited the damage, but they didn’t undo it. Even with them, the total return version of the S&P 500 was still around 14% lower 10 years after Sept. 1, 2000.
The valuation itself fell hard over that decade. The ratio dropped from 43.77 in January 2000 to around 21 in January 2010, under half its earlier level.
What can one episode show investors?
True, the 1999-2000 record looks lopsided. But it’s actually one episode, not 21 separate ones. These monthly starting dates overlap a lot, so they arguably act more like a single data point than a pattern.
Of course, the 10-year windows also include the 2008 financial crisis, which had its own causes.
The ratio can also read high for a mechanical reason. Because it uses a 10-year average of earnings, a stretch of fast profit growth can leave that average far behind what companies earn today, which raises the ratio compared with a regular price-to-earnings ratio.
Still, I think the episode is worth taking seriously for what it says about buying at this sort of price and holding for a decade. I wouldn’t rely on the ratio for timing, though. It’s now been above 40 since May, and in 1999 it stayed there for a full year as stocks kept climbing.
I wouldn’t get out of the S&P 500 over a reading of 41. But I’d expect less from the next 10 years than the past 10, when the index gained around 14% a year on price alone.
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