Chicken Little, meet CAPE

Posted on Mar 05, 2017 by in Letters

http://stockcharts.com/h-sc/ui?s=%24SPX&p=D&yr=0&mn=6&dy=0&id=p70142979615&a=266398464

The musical score of this market is furnished by chickens clucking.  Incessantly.  The more the sky doesn’t fall the more insistent the clucking becomes.  The P/E ratio is too high.  Cluck cluck.  S&P P/E 26.75 at the moment, against an average of 15.64 (median 14.65, minimum 5.31, maximum 123.73).  A good time for a teachable moment.  The P/E is not a definitive indicator.  It is a debateable tool in the never ending search for the philosopher’s stone — which ever flees before us like a holy grail.  And there is no known tool which reliably identifies the top.  Long term trendline breaks  are very useful, and even short term breaks are indicative.

Nonetheless we are where we are.  And the party is long lasting and so it pays to be alert.

http://stockcharts.com/h-sc/ui?s=%24SPX&p=W&yr=1&mn=6&dy=0&id=p54500024487&a=268628380

The last wave here looks vulnerable and of course the eternal pattern is wave up, wave down.  The steeper the curve the more likely a correction.  Much (much!) experience has shown that attempting to fine tune (or fine time) the market invariable loses to the long term approach which sits out corrections and only exits when the long term trend changes — in our case as marked by a violation of the basing points procedure (Chapter 28, Technical Analysis of Stock Trends, 10th Edition).

One of the dreamers who pursues the Holy Grail is Professor Shiller who has complicated the question of the p/e by creating the CAPE.  Not the Batman cape, but the cyclically adjusted price earnings ratio.   This is price divided by the moving average of 10 years of earnings– and, of course, adjusted for inflation.  (Currently the CAPE is 27.7 — a ratio which has only approached this level in 1929, 2000, and 2007.)  We have said that if the CAPE bothers you you should tell your broker when you call him to only buy CAPE adjusted stocks.  (A harmless academic joke.)

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