US stocks are cheaper than they look – but are they cheap enough?

Adjusted for low interest rates, US stocks are not as pricey as they seem. But you may still be better off elsewhere, says John Stepek.

Robert Shiller
Professor Robert Shiller: tweaking the Cape
(Image credit: © REUTERS / Alamy Stock Photo)

One of our favourite valuation ratios here at MoneyWeek is the cyclically-adjusted price/earnings ratio (Cape). The Cape – also known as the Shiller Cape, after Professor Robert Shiller, who popularised it – is similar to a standard p/e ratio (see below) in that it looks at how expensive a company or index is relative to the earnings it generates. But rather than a single year of earnings, the Cape takes average real (inflation-adjusted) earnings over ten years. This smooths out cyclical ups and downs and gives a clearer picture of whether a market is truly cheap or not. History shows that buying an index when the Cape is low (ie, it’s cheap) will deliver the best returns, while buying when the Cape is high (ie, the index is expensive) is a bad idea.

However, in recent years there’s been a bit of a fly in the ointment – the Cape doesn’t seem to be working. The S&P 500 index in the US in particular has looked massively overvalued for many years (not just on the Cape, but on plenty of other measures too). Yet it keeps hitting new highs.

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John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.