The ability to predict the stock market is like the Holy Grail.
Unfortunately, there’s no shortage of bad forecasters who sell a bill of goods.
Some are one-hit wonders.
Others, like Rich Dad, Poor Dad author, Robert Kiyosaki are like broken records.
Every year for the past two decades, he says stocks are going to crash.
Every. Freaking. Year. But one forecaster stands above the rest.
It isn’t a man.
It isn’t a woman.
But like a superhero, it does wear a cape.
In this case, CAPE stands for cyclically-adjusted-price-to-earnings ratio.
In fact, it’s the world’s best stock market predictor.
No other forecasting method is approved by peer-reviewed economic science.
Haven’t heard of it?
I’m not surprised.
Millions are familiar with the Kardashians and the eye candies on The Bachelor and the Bachelorette.
Meanwhile, brilliant people without six packs and chest augmentations, like Robert J. Shiller, aren’t kissing strangers on TV screens.
In 2013, the Yale University professor won a Nobel Prize in Economic Sciences.
He also devised the CAPE ratio.
It’s the best predictor of how stocks will perform.
It compares a stock market’s current price level to the average annual earnings of that market’s businesses over the previous ten years, adjusted for inflation.
That might sound like Swahili, so let’s unpack the parts.
You’ve likely heard of a PE ratio (price-to-earnings ratio).
A PE ratio measures the cheapness or expensiveness of a stock.
To determine that, we figure out how much it would cost to buy 100 percent of that company.
We simply multiply the company’s share price with the total number of shares that exist.
For example, if a stock’s price was $1 a share, and 1 million shares existed, it would cost $1 million to buy the business outright.
This is known as the company’s “market capitalisation.”
The PE ratio determines how many years it would take to buy the entire company based on that company’s previous year’s net income.
For example, assume a business earned net income of $50,000 last year.
If the business’ market capitalisation were $1 million (the value of every share multiplied by the current share price) then that company would have a PE ratio of 20 times earnings.
In other words, it would take 20 years worth of the previous year’s net income to earn $1 million (thus having enough money to theoretically buy the company outright).
A stock with a PE ratio of 20 would be cheaper than a stock with a PE ratio of 40.
The CAPE ratio is like that. But it’s stricter.
It measures how expensive an entire stock market is.
However, it doesn’t base that calculation on the previous year’s earnings.
For example, with a traditional PE ratio, an unusually good or unusually poor earning year could make a stock (or the stock market) look cheaper or more expensive than it really is.
In contrast, the CAPE ratio averages out a stock market’s previous 10 years' worth of business earnings, adjusted for inflation, and compares that to the current price.
Here’s why academics love it.
Shiller found that when a stock market’s CAPE ratio is significantly higher than its historical average, a poor decade of returns typically lies ahead.
In contrast, when the CAPE ratio is much lower than its historical average that bodes well for returns over the next ten years.
Thanks to the recent stock market drop, US CAPE ratios are lower now than they’ve been since 2017.
European stocks are even better.
Since 1985, they’ve only had a handful of moments when they were this cheap.
I can hear what you’re thinking.
“Europe is struggling with a war on its doorstep, and the British Prime Minister is now running from her house.”
And that’s exactly my point.
Stock markets perform best in a place of trouble.
That’s why, based on current CAPE ratios, European stocks (and emerging market shares) should thump the returns of US stocks over the next ten years.
But don’t turn your back on US stocks.
Yes, the CAPE ratio is an uncanny predictor of a future decade’s performance.
But it doesn’t predict shorter time periods.
For example, assume US stocks averaged just 2 percent per year over the next ten years.
If that happened, one thing is certain.
It wouldn’t be a smooth 2 percent annual return because year-by-year stock market returns are never consistent.
US stocks could soar for 6 years, fall hard in year 7, hit a new all-time high 8 years from now, and then drop slightly each year for the decade’s final 2 years.
That could see them averaging just 2 percent over the ten-year period.
Meanwhile, assume European stocks averaged 8 percent annually over the next ten years.
They could flat-line for the first 8 years, and then make huge gains during the final two.
If someone had a globally diversified portfolio of index funds or ETFs, they could rebalance their geographic exposure once a year, simply maintaining their target allocation.
That would mean selling pieces of their US stock indexes during the years they soar while adding those proceeds to their underperforming assets.
And during years when US stocks sank (compared to bonds, European shares or emerging market shares) investors should sell pieces of the better-performing investments to add money to the sinking US stocks.
Such rebalancing reduces risk, and sometimes, it can even boost returns.
So, while the CAPE ratio is the world’s most reliable stock market forecaster, it pays to think long-term, maintain a consistent allocation, and ignore the useless rambling of forecasters and our guts.
Andrew Hallam is the best-selling author of Millionaire Expat (3rd edition), Balance, and Millionaire Teacher.
