The CAPE Is Extreme Again, Should You Reduce Exposure To The S&P 500 Now?

Let's take a closer look. The table below summarizes average annualized returns around months when the CAPE is at extreme highs or lows. The table includes annualized real returns for the ten-years prior to each designated month, as well as for the ten years following the month. The average CAPE is equal to 17 during the 1900 to 2017 period, so we define extreme CAPE ratios as less than 10 or more than 24. For the 1980 to 2017 period, the average CAPE is equal to 22, so we define extremes as either less than 13 or more than 27.

In both periods, when the CAPE ratio was extremely low (less than 10 and 13, respectively), returns during the preceding ten years were negative (-4.6% and -3.2%, respectively) and the returns for the following ten years were quite positive (6.0% and 7.3%). These periods, in which US equities were cheap, represented very good times to invest.

Conversely, when the CAPE ratio was extremely high (more than 24 and 27, respectively), annualized returns for the preceding decade were positive (8.6% and 9.9%, respectively), and returns for the following ten years were negative (-0.1% and -1.5%). These returns are modestly negative, but imagine generating no return for a decade – why would we choose to be exposed to that risk? Further underscoring this argument, if we examine months when the CAPE ratio is above 30, the average annualized return for the following ten year period is -8.05%. Better to stay away.

We have shown above that CAPEs provide useful information as they hit extreme levels – when they are elevated, they provide useful early warning information, and when they move too low, they indicate that it may be an excellent time to invest.

Currently, the Cyclically Adjusted Price Earnings Ratio is equal to 31.2. This is well above the threshold for extreme CAPES during both periods. This suggests that the S&P 500 is likely to deliver modest returns over the next decade. Below, we regress ten year returns on the CAPE from 1980 to 2017. This forecasts a negative annualized return (-2.5%) over the next ten years.

Conclusion

Determining when CAPE ratios are at extremely high levels, as they are today, provides useful risk management insights about risk management. Clearly, at current levels, this suggests that it makes good sense to be reducing exposure to US equities.