Stock jitters? Look past the CAPE

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  By Guest Blogger Sinan Terzioglu

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Despite uncertainty surrounding global trade and ongoing geopolitical tensions, the U.S. equity market has outperformed expectations this year, with the S&P 500 gaining 15% year-to-date. Technology stocks have led the rally, driven by a surge in capital investment in artificial intelligence. However, the combination of aggressive spending and historically high valuations has raised concerns that the market may be getting ahead of itself.

I was recently asked:

In October, the CAPE ratio for the U.S. equity market rose to 40, it’s highest level since the dot-com era in 1999. According to a recent report, economist Robert Shiller projects that the S&P 500 may deliver annualized returns of just 1.50% over the next decade. While I recognize the strong fundamentals of the U.S. market, especially in the technology sector, current valuations appear significantly stretched.
 
This environment increasingly resembles the conditions that preceded the dot-com bust, which, as you know, led to a lost decade for large cap U.S. stocks. Given today’s elevated CAPE ratio, I’m considering whether it might be a good time to sell my U.S. equity ETFs and wait for a significant market correction?

The Cyclically Adjusted Price-to-Earnings (CAPE) ratio, created by Nobel laureate Robert Shiller in 1988, is widely recognized as a key measure for evaluating equity market valuations. It calculates the ratio of current prices to the average of inflation-adjusted earnings over the previous ten years. This approach helps provide a more consistent and long-term view of equity valuations by minimizing the impact of short-term fluctuations in corporate earnings over a business cycle. However, the CAPE ratio has shown notable weaknesses over time, which makes it an unreliable indicator of future returns.

First, it assumes a static mix of stocks and sectors over time, which fails to reflect the dynamic evolution of the S&P 500. Since the 2010s, the index has shifted significantly toward capital-light, high-margin industries such as technology and healthcare. This stands in stark contrast to the 1980’s, when capital intensive manufacturing companies accounted for roughly 60% of the index, compared to approximately 15% today.

This structural transformation has contributed to a significant improvement in corporate profitability, with expanding profit margins, lower earnings volatility, and more resilient, sustainable average profits. Yet, the CAPE ratio does not adjust for these changes, limiting its effectiveness as a valuation tool in the modern era.

Second, the CAPE ratio does not account for share repurchases, which have become a dominant method of returning capital to shareholders since the mid-2010s. While dividends were traditionally the primary way of distributing profits, share repurchases now represent more than half of total capital returns in the S&P 500 and are projected to exceed $1 trillion in 2025.

Apple alone has repurchased over $700 billion of its own shares over the past decade – an amount exceeding the market capitalization of 488 companies in the S&P 500 index. Remarkably, only 13 companies worldwide have a market cap larger than the value of Apple’s repurchases. Yet, the CAPE ratio disregards the impact of reduced share counts from major index holdings like Apple when assessing valuation.

Third, the CAPE ratio has had a consistent tendency to underestimate actual long-term investment returns. Since gaining popularity in the late 1980s, research has shown that the ratio’s forecasts for U.S. equity performance have fallen short—often by 5 to 10 percentage points—compared to what investors have ultimately realized.

This shortfall is largely due to the CAPE’s conservative methodology of averaging earnings over a 10-year period. While this approach helps smooth out short-term volatility, it can obscure more recent improvements in corporate profitability. Moreover, the ratio fails to account for significant structural shifts in the economy, such as technological innovation and operational efficiencies, all of which have contributed to a sustained expansion in profit margins. As a result, the CAPE ratio may paint an overly cautious picture of future returns, potentially leading investors to underestimate the strength and resilience of modern equity markets.

In summary, although today’s elevated CAPE ratio points to the likelihood of lower U.S. equity market returns over the next decade compared to those of the past ten years, accurately predicting annual returns is highly uncertain. No single valuation metric can reliably forecast future performance. Equity markets are influenced by a complex and ever-changing mix of factors, many of which are difficult to anticipate. Overreliance on any one valuation measure can result in overly conservative or misguided investment decisions.

Rather than viewing the CAPE ratio as a reason to exit the U.S. equity market entirely, investors are better served by managing risk through a balanced and globally diversified portfolio. This includes maintaining exposure to small-, mid-, and large-cap stocks across the U.S., Canada, and international markets, while adjusting allocations as conditions evolve. Diversifying across sectors is equally important, as different industries respond differently to economic cycles, technological innovation, and policy developments. A well-constructed portfolio can help smooth out volatility and support long-term growth, even in the face of valuation concerns.

Sinan Terzioglu, CFA, CIM, is a financial advisor with Turner Investments, Private Client Group, Raymond James Ltd.  He served as vice-president of RBC Capital markets in New York City and VP with Credit Suisse in Toronto.

Source: https://www.greaterfool.ca/2025/11/09/stock-jitters-look-past-the-cape/