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Victor Haghani and James White

What If High Stock Values Revert to Normal Levels?

Cyclically adjusted price-to-earnings ratios should not be one of many reasons to worry about current U.S. stock prices.
Stock valuations are near historically high levels.

Stock valuations are near historically high levels.

Photographer: Spencer Platt

There may be many reasons to worry about the current record price levels of U.S. equities, but agonizing over the fallout from valuations reverting back to their historical averages should not in itself be high on the list. In fact, deviations from the mean for one popular valuation measure -- the cyclically adjusted price-to-earnings ratio -- don’t actually tell us much about expected market returns.

What makes this particularly important now is that the CAPE stands at 30. The CAPE was equal to higher than it is today in only 59 of the 1,640 months going back to 1881, or less than 3.6 percent of the time.  On average it takes about five years for the CAPE to move halfway back to its 16.8 historical average, based on a simple regression analysis.

Investors are understandably concerned that if it’s correct to expect the market to revert to a CAPE of about 24 over the next five years, then equities should drop about 22 percent, assuming earnings stay constant. No wonder so many are waiting for a stock market correction before putting more of their savings to work.