This ‘100% Accurate’ Stock Market Indicator Predicts a 30% Crash – Should You Trust It?

Summary

In this video, the speaker addresses concerns about the overvaluation of the stock market, particularly regarding the S&P 500 and the Shiller PE ratio (Cape ratio). They explain the limitations of using the Cape ratio as a short-term forecasting tool and highlight its shortcomings due to changes in tax policies, company structures, and accounting methods. The speaker stresses the importance of a long-term investment strategy, urging viewers to focus on consistent investing rather than trying to time the market. While acknowledging high valuations, they emphasize that market corrections are inevitable and should be seen as opportunities for growth.

Takeaways

• 😀 The CAPE ratio is often misused as a short-term market forecasting tool, but it is meant to indicate long-term market returns over the next 10 years.
• 😀 A headline suggesting the S&P 500 could plunge 30% based on the CAPE ratio is vague and unreliable for immediate action.
• 😀 The S&P 500 has had strong returns (e.g., 25% in 2024) despite the CAPE ratio being above 30, which shows that market movements don’t always follow historical patterns.
• 😀 Historical concerns about market bubbles based on the CAPE ratio (such as in 2014 and 2016) often proved inaccurate, as the market continued to grow.
• 😀 While the CAPE ratio suggests high valuations by historical standards, it has limitations in accurately predicting future market behavior.
• 😀 The stock market's mix of companies has drastically changed, especially with the rise of tech giants like Apple, Microsoft, and Nvidia, which has skewed the CAPE ratio’s relevance.
• 😀 Changes in tax policies, such as the 2017 Tax Cut and Jobs Act, have affected corporate profits and make historical comparisons less relevant.
• 😀 The CAPE ratio does not account for share buybacks, which can make companies appear more profitable and inflate the ratio.
• 😀 Low interest rates over the last few decades have increased the present value of stocks, making it misleading to compare the CAPE ratio with periods of high interest rates like the 1980s.
• 😀 Modern businesses have improved profit margins due to advancements like technology and outsourcing, which can justify higher CAPE ratios today.
• 😀 Long-term investing, consistent contributions, and accepting market corrections are key to financial success, rather than attempting to time the market based on short-term predictions.

Q & A

What is the Schiller PE ratio (CAPE ratio) and why is it used?

The Schiller PE ratio (CAPE ratio) is a valuation measure that adjusts the traditional price-to-earnings ratio by averaging inflation-adjusted earnings over the past 10 years. It's used to assess the probability of future returns for the S&P 500 over a 10-year period, providing insights into long-term market trends.

What is the significance of a CAPE ratio above 30?

A CAPE ratio above 30 typically suggests that the market is highly valued, historically signaling potential overvaluation. However, it doesn't predict short-term market movements, and high CAPE ratios can still coexist with strong market performance for several years.

Can the CAPE ratio predict short-term market movements?

No, the CAPE ratio is not a reliable short-term market predictor. It is meant to give an indication of long-term stock market returns, typically over the next 10 years, rather than predicting short-term corrections or crashes.

How did the S&P 500 perform in years when the CAPE ratio was above 30?

Despite the CAPE ratio being above 30 in years like 2021 and 2024, the S&P 500 performed very well, increasing by 29% in 2021 and 25% in 2024, demonstrating that a high CAPE ratio doesn't always correlate with a market decline in the short term.

Why are historical comparisons of the CAPE ratio potentially misleading?

Historical comparisons of the CAPE ratio can be misleading because the composition of the S&P 500 has changed significantly over time. Today’s index is more tech-heavy, with companies like Apple, Microsoft, and Nvidia dominating, which impacts profitability and growth rates differently than older companies.

What role have tax policies played in changing market dynamics?

Tax policies, such as the 2017 Tax Cuts and Jobs Act, have lowered corporate taxes, allowing companies to retain more profits. This has contributed to higher valuations and makes comparisons to historical tax regimes less relevant for evaluating current market conditions.

How have share buybacks impacted the CAPE ratio?

Share buybacks have artificially inflated earnings per share (EPS) by reducing the number of outstanding shares. This makes companies appear more profitable, even if their total profits haven't increased, leading to a distorted view of their valuation when using the CAPE ratio.

How do low interest rates affect stock valuations?

Low interest rates reduce the discount rate used to value future earnings, which increases the present value of stocks. This makes stocks appear more valuable, meaning that comparing current CAPE ratios with those from periods of high interest rates can be misleading.

What impact have accounting changes had on the accuracy of the CAPE ratio?

Accounting changes over time, such as different rules for how companies report earnings, can lead to inconsistencies in the data used for the CAPE ratio. These differences make it difficult to compare the current CAPE ratio with historical ones, as older earnings numbers may not align with today's accounting standards.

What are the key limitations of using the CAPE ratio as a market predictor?

The CAPE ratio has several limitations, including its assumption of a constant mix of stocks over time, failure to account for modern tax policies, share buybacks, changes in interest rates, accounting rules, and the invisible value of tech companies. These factors make historical CAPE comparisons less relevant in today's market.