Long-term markers

A PE over a single year can mislead. A recession crushes profits, a boom inflates them. You need longer markers.

The economist Robert Shiller proposed a solution: compare the price with average profits over the last ten years, adjusted for inflation.

That is the CAPE, also called the Shiller PE. It smooths out cycles, and looks at companies over a whole decade.

For the American market, its historical average is around sixteen or seventeen.

In nineteen twenty-nine, it passed thirty. In late nineteen ninety-nine, it reached forty-four, its record. Two peaks, two crashes.

Flip it: a CAPE of forty is a two and a half per cent earnings yield. A CAPE of ten is ten per cent.

A high CAPE signals, on average, lower returns over the next ten years. The link shows over long periods.

But it says nothing about timing. A market can stay expensive for years, and keep rising.

Second marker: the risk-free rate. It is what the safest possible loan pays, usually to a solid state.

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Everything is measured against it. Why take a risk, if you can earn as much without risk?

When it rises, everything else is worth less. Say one hundred euros a year, forever. At five per cent, that flow is worth two thousand euros.

At six per cent, it is worth only about one thousand six hundred and sixty-seven euros. One point of rate, and a sixth of the value disappears.

Third marker: the equity risk premium. It is what shares must earn on top of the risk-free rate.

For the example: if you expect seven per cent from shares, and risk-free pays three, the premium is four points.

Nobody observes it directly. It is estimated, usually between three and six points depending on the method. It is one of the most debated numbers in finance.

When the premium is thin, shares are expensive. When it is wide, they pay well for the risk you take.

Last marker: Tobin's q, named after the economist James Tobin. You compare stock market value with the cost of rebuilding the company.

If q is above one, it is better to create companies than buy them. If it is below one, better to buy them on the market than build them.

This marker has its limits: a brand, software, a patent are hard to price at replacement cost.

None of these markers can guess next month. They tell you where you are starting from.

Starting from an expensive market is no death sentence. But it invites you to expect less, and to prepare for more jolts.