Making sense of the markets this week: July 5, 2021 | MoneySense

Everything you need to know about the CAPE ratio

We’ve talked a lot about valuations in this space. Valuation mostly refers to the current earnings (profits) you are receiving when you buy a stock. Remember that when you buy a stock you are becoming a part-owner of that business. And as a business partner, you own a portion of the profits and any dividends, along with the debt and other liabilities. 

We mostly want to own profitable companies. If you give a company $100 and they earn $10 for you on the $100, that’s a very profitable investment. It might be better than buying into a company that earns 50 cents for you on your $100 investment. Yes, it might take a while to earn or get your money back, and the pace of growth of the company is also a great consideration. A company might not have considerable current earnings, but if they are growing revenues at a rapid pace, there is the strong prospect of generous future earnings. 

In mid-February, we looked at Shopify’s earnings and growth. While the Canadian tech darling was new to the game of actually turning a profit, its growth was, and remains, incredible. Investors were rewarded for the growth thanks to higher and higher stock prices. 

In simple terms, investing in stocks might come down to current earnings and future prospects. 

With respect to valuations, you may have heard of the CAPE ratio. CAPE stands for cyclically adjusted price-to-earnings (ratio). Cyclically adjusted means that the valuation method will smooth out the rough edges of any data over time. It is said to offer a more true reading of valuations and the prospects for future stock returns. It can’t predict the timing of stock market corrections, but it does offer a very good reading on returns prospects over time. 

This link from Meb Faber, the chief investment officer at Cambria Investment Management, shows that a very high CAPE (lower earnings) ratio mostly delivers very low returns over a 10-year period. A low CAPE ratio (higher earnings) mostly delivers very generous earnings over a 10-year period. But it’s not an exact science. There are outliers. But, mostly, earnings matter over time. 

In fact, earnings offer 80% of the explanatory power for stock performance, according to this tweet from Scott Barlow of the Globe and Mail, referencing a Bank of America study. (Look for item No. 2 on that list.)

So, yes, investors might want to curb their enthusiasm with respect to U.S. stocks. 

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