A classic sign of a bubble in US stocks

Bullish investors in American equities have called a key stock-market metric into question.

Robert Shiller's Cape ratio has "gained wide acceptance as an accurate gauge of the stock market", writes John Authers in the FT. But the Cape or cyclically adjusted price/earnings (p/e) multiple which compares share prices to average earnings over ten years is "under attack" from rival economist Jeremy Siegel.

The Cape currently signals that the American stock market is overvalued by 62% and "more expensive than any other big stock market". However, Siegel claims the ratio as it stands has an in-built bias that makes current equity prices look more expensive than they are, and many investors agree.

Savita Subramanian, head of US equity and quantitative strategy at Bank of America Merrill Lynch, claimed last month that "15 other measures showed the US market to be either cheap or at fair value". Meanwhile, investors complain that, besides a dip during the March 2009 crash, the Cape has implied that US equities have been overvalued for 22 years.

As such, Siegel has created his own version of the Cape, which he believes corrects the problem by adjusting for company write-downs, "which were extreme for financial companies in 2008 and 2009". Siegel's revised Cape suggests that US equities are cheap.

However, says Authers, defenders of the Cape, which remained well above its average from 2003 to 2007, suggesting that the rally was unsustainable (which it was), note that a classic sign of a bubble is "casting doubt on metrics" that don't tell the story the bulls want to hear.

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