Recently, the S&P 500 (SNPINDEX:^GSPC) cut through the 1,900 level like a hot knife through butter. As each new numerical milestone falls, investors are left wondering whether this bull market is reaching its pinnacle. Unfortunately, there's no certain way to know when a market is reaching a top or bottom. However, one person who has a stellar track record of predicting market tops is Yale economist and Nobel laureate Robert Shiller. So let's take a look at what Shiller's CAPE metric is currently telling us about the stock market.
The CAPE crusader
In March 2000, Robert Shiller released his book Irrational Exuberance at the height of the dot-com bubble. And on several occasions between 2003 and 2007, Shiller published papers and made public predictions about the collapse of the housing market. In Irrational Exuberance, Shiller often references CAPE, which is an acronym for cyclically adjusted price-to-earnings ratio. That may sound impressive, but all Shiller has done with this metric is tweak the denominator in the familiar price-to-earnings (P/E) ratio. Instead of using the previous four quarters of earnings, Shiller uses an average of the previous 10 years of earnings. This simple modification smooths out the earnings number by eliminating the influence of short-term earnings fluctuations.
So when you take the CAPE for the S&P 500 throughout history and adjust for inflation, you get this graph:
The blue line shows how CAPE for the S&P 500 has fluctuated over time. The black horizontal line I added represents a CAPE of 16.5, which is the mean historical CAPE. The red line represents a CAPE of 25 and is included because the CAPE recently rose past 25 for the first time since early 2008.
A history lesson
It's clear that the current CAPE is well above its historical mean of 16.5. But since 1881, the S&P's CAPE has been above 25 (the red line) only 8.9% of the time.
In fact, the CAPE has only crossed above the 25 level four other times in history. The first time was in June 1901. From June 1901 to November 1903, the Dow Jones dropped more than 46% in what was later known as the Panic of 1901. The next time the CAPE crossed above 25 was November 1928. Of course, "Black Tuesday" occurred about one year later, and from mid-1929 to mid-1932 the Dow dropped 96% as the Great Depression set in.
After the Great Depression, the CAPE remained below 25 for decades until December 1995. At the height of the dot-com bubble, the CAPE peaked at over 44 in December 1999. When the bubble burst a month later, the Dow dropped about 20% from January 2000 to March 2001. The most recent time the CAPE breached the 25 level was in the end of 2003, during the housing bubble. We all remember the financial crisis that resulted -- and the subsequent 50% drop in the Dow from 2007 to 2009.
CAPE is not a crystal ball
While CAPE is certainly a helpful way to keep tabs on how expensive stocks are, it has its limitations. For example, CAPE gives no indication of exactly when a peak will occur. If you had sold all your stocks when the CAPE reached 25 in 2003, you would have sold when the S&P 500 was at 1,000. You would have avoided the market crash in 2008-2009, but you would have been waiting for it to happen for about four years, and you would have missed the more than 50% rise to the S&P 500's peak of over 1,500 in October 2007!
So with a current CAPE of 25, are stocks expensive? Yes. Is a market correction coming at some point? Almost certainly. Does the current CAPE above 25 mean the end of the bull market is imminent, as it did in 1928, or will we see another 50% rise in the market like we did from 2003 to 2007? Only time will tell.
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Wayne Duggan is the author of Beating Wall Street with Common Sense and the developer of tradingcommonsense.com. Wayne Duggan has no position in any stocks mentioned. The Motley Fool recommends Johnson & Johnson. The Motley Fool owns shares of General Electric Company and Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.