Professional money managers use various tools to measure the value of an investment. One common measure is the Price/Earnings ratio. To get a P/E ratio, take the price of a stock and divide it by its earnings. We will use Facebook. The closing price for FB (its ticker symbol) on Friday was $172.45 and its earnings per share was $3.93. So, the P/E ratio for Facebook is 43.88. This tells us what an investor should be willing to pay for per dollar of earnings. Here is a chart of the history of Facebook’s PE Ratio.

We can also consider the P/E ratio for the broader market. If we use the Standard & Poor’s 500 Index to represent the US stock market, we find that the P/E ratio is 24.65. The P/E ratio can be problematic, because it represents a moment in time, lacks historical context and is just one variable that can be used to value a stock or the market overall. To obtain broader perspective, Robert Shiller, a professor at Yale University, developed the cyclically adjusted price earnings ratio. The CAPE is calculated by dividing the current market price by the average inflation adjusted earnings over the last 10 years. The CAPE smooths data for business cycles.

The CAPE ratio for the S&P 500 is currently 30. You can see the CAPE ratio dating back to 1880 here. You will notice a few things. The CAPE ratio has averaged about 16 since the late 1800s. So, the market is valued at almost twice its historical average. Also, the last time the CAPE ratio was at this level was in 1929 and again in 2000. We know what happened in the aftermath of those periods – The Great Depression and the Tech Crash. (Notably, the CAPE ratio did not reach the current level in advance of the Great Recession).

Professor Shiller was on CBNC a few days ago discussing his tool and the value of the market. We share Professor Shiller’s concern that markets are likely are overvalued and that some kind of reversion back to the average is looming. He does not make any predictions about how or when this will happen and nor will we. However, we do caution investors to prepare themselves for what is likely the inevitable.

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