Stockmarket valuation gauge moves into the red

One sign of a stockmarket party that has gone on too long is a stretched cyclically adjusted price/earnings (Cape) ratio. Cape has been among the most reliable valuation gauges in market history. While it’s not a useful indicator of a crash or boom in the short term, history shows that the higher the Cape, the lower long-term returns are likely to be.

In the US, the Cape has reached 26, compared to an average over the past century of 16. It has spent over 90% of the past 134 years at a lower level, according to data from Deutsche Bank.

Only on two occasions has the S&P 500 been more expensive by this measure. Cape was marginally higher at the peak of the market in 2007. It reached 44 in 2000, an all-time high at the peak of the tech bubble. The previous high was 33 in 1929. At major bear-market bottoms, Cape has been in single digits.

So, the historically high Cape suggests equity investors are likely to struggle from here. It hardly helps matters that US profit margins are unusually high and thus likely to fall. The macroeconomic environment of the next few years is a further likely headwind. One key problem is demographics.

The growth rate of the US working-age population has collapsed from 7.3% in 1995-2000 to 2.1% today, as Deutsche points out. Debt remains historically high, while the rest of the world is still working off its hangover from the crisis. Add it all up and Deutsche reckons US stocks could lose an annual 0.9%, or 3.4% in real terms, over the next ten years.

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