The stock market valuation chart we want now but can’t have until 2035

An alternate version of this article initially appeared on TKer.co.

Current valuation metrics suggest that the stock market may be overpriced, leading many investors to brace for less promising returns in the future.

However, it is essential to recognize that valuation metrics can be misleading, and their interpretations can sometimes steer investors off course.

To better understand the landscape, let’s take a closer look at three commonly referenced valuation ratios:

• Forward Price-to-Earnings (P/E): Currently sitting at around 22x, this ratio exceeds its historical averages. Investors value this metric as it relies on earnings projections for the coming twelve months. The underlying principle is that a stock’s value correlates significantly with its anticipated earnings. However, the limitation of the one-year forward P/E lies in its short-term focus, neglecting the several years of earnings that influence a company’s total value.

• Trailing P/E: With current values close to 28x, this ratio also surpasses historical averages significantly. It derives its numbers from earnings over the past year. Its main advantage is based on actual earnings figures, avoiding the pitfalls of predictions. Yet, this backward-looking attribute can be a drawback, especially considering that the stock market generally operates with a forward-looking perspective.

• Cyclically-Adjusted P/E (CAPE): At 40x, the CAPE ratio is reported to be at its highest level since the dot-com bubble. This ratio, uniquely, averages out the earnings over a decade, smoothing over the volatility seen in annual earnings. Yet, it shares the common disadvantage with previous ratios of being retrospective in its analysis.

Ideally, an effective valuation model would incorporate an extensive range of anticipated future earnings—this approach mirrors the function of discounted cash flow models. Predicting future earnings, however, is a complex task, often more challenging than anticipating the next quarter’s performance.

As a thought experiment, consider the possibility of a P/E ratio that evaluates earnings based on projections for the next decade. Such a metric would blend the advantages of both forward P/E and CAPE.

This led to a discussion on X last week.

While predicting earnings up to 2035 presents inherent difficulties, we can retrospectively analyze data from 2015 onward to construct what we could term “forward-realized CAPE.”

This hypothetical measure evaluates a valuation ratio derived from the average of the next decade’s realized earnings, helping us ascertain whether the market was undervalued or overvalued during that timeframe.

Kudos to Jake (@EconomPic on X) for previously proposing this concept over a year ago.

In the accompanying chart, you will see Shiller’s CAPE displayed in red juxtaposed with the forward-realized 10-year earnings CAPE represented in blue.