The investment of capital often takes one on a perilous journey through deep woods of at-times bewildering economic phenomena. The task of navigation is a never-ending quest that requires arriving at a rational estimate of the intrinsic value of assets or even entire markets. Executing this objective with relative success is the means to safe passage through the forest.
The price of an asset is as proximate to most investors as their smartphones. This often deceives the unwary, for it is the arduous task of determining the intrinsic value of that asset which is the key to investment success. Value is, to a greater or lesser degree, a function of the vagaries of future events. Precision is most difficult. Frequently, the more reasonable objective is to conclude that the current price is sufficiently above or below the intrinsic value to warrant a purchase or justify a sale. Certainty beyond this is generally unattainable.
Rational investors, accordingly, should seek reliable metrics to gauge the overall expensiveness or cheapness of markets. While many default to the conventional price-earnings (P/E) ratio, its limitations necessitate exploring more robust tools. Among these, the Shiller Cyclically Adjusted Price-Earnings ratio (CAPE), Warren Buffett’s market-cap-to-GDP ratio, and Tobin’s Q stand out. These tools offer a deeper and more holistic view of market valuation, arguably making them superior to the standard P/E ratio. Because of the vast range of quantitative and qualitative differences among the companies of which indices are composed, the application of the three metrics to individual asset valuation is more nuanced.
The Good, the Bad, and the Misleading
The standard P/E ratio is calculated by dividing the current market price of a stock—or market basket of stocks—by its earnings per share (EPS) over the most recent 12-month period. While straightforward and easy to understand, the P/E ratio’s simplicity is also its downfall. The primary weakness is its susceptibility to the cyclical fluctuations of earnings. As a residual, earnings can be exceptionally volatile, influenced by macroeconomic events, company-specific factors, and accounting adjustments. Today’s S&P 500 PE is 23.5, based on earnings that have benefited from massive fiscal stimulus and, up until a year ago, zero-cost money. That ratio will likely prove misleading.
Shiller CAPE Ratio
Developed by Nobel laureate Robert Shiller, the CAPE ratio uses the inflation-adjusted average of earnings over the last 10 years, rather than just the last 12 months. This approach smooths out cyclical fluctuations and offers a valuation less sensitive to short-term trends. Historically, the highest CAPE ratio for the S&P 500 was 44.2 in December 1999, during the dot-com bubble. The lowest was 4.78 in December 1920, and the historical average has been 17.4.
Warren Buffett famously referred to the market-cap-to-GDP ratio as one of his favorite market-valuation tools. It measures the total value of all publicly traded stocks in a nation as a percentage of national GDP. For the United States, it reached approximately 177% at the end of 2020, was around 35% in the mid-1970s, and has a historical average of roughly 80–90%.
James Tobin, another Nobel laureate, developed the Tobin Q ratio. It compares the market value of a firm to the replacement cost of its assets. A Tobin Q above 1 suggests that the market values the company above the cost of its tangible assets, potentially indicating overvaluation. The highest recorded Tobin’s Q ratio was around 2.4 in the first quarter of 2000, the lowest was approximately 0.3 in the first quarter of 1980, and the average is 0.68.
Forest Is Not without Hazards, It Bears Mentioning
Despite the availability of such advanced metrics, many investors, particularly those with little or no professional training, often rely on emotions or gut feelings when making investment decisions. Behavioral-finance studies have repeatedly shown how emotions, biases, and heuristics can significantly affect decision-making. In volatile markets, fear and greed can become dominant drivers, leading investors astray. In such scenarios, emotional decisions can result in buying high and selling low—the opposite of successful investing.
It is therefore crucial for investors, whether professional or amateur, to arm themselves with reliable valuation tools that offer a clearer perspective. The Shiller CAPE, market-cap-to-GDP ratio, and Tobin Q are precisely such instruments. They provide a more holistic view, mitigating the impact of short-term distortions and emotions.
Navigating with a Better Compass and …
While no single metric can claim perfection in the realm of market valuation, combining multiple robust tools can provide a comprehensive perspective. The three aforementioned tools have proven their mettle over time by taking into account the inherent shortcomings of the standard P/E ratio. By familiarizing themselves with these superior instruments, investors can make more informed decisions, ensuring that they aren’t being guided by fleeting emotions or short-term market noise. Investing, after all, is as much art as science.
The current Shiller CAPE P/E is 30.8, the market-cap-to-GDP ratio is 165.2, and Tobin’s Q is 1.38—each double its historical average.
When venturing into the financial forest, don’t spare the compass… nor the bear spray.