In today’s Finshots, we talk about the CAPE ratio and whether it is a reliable metric for predicting stock market crashes.

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The Story

Let’s talk about stock market crashes.

Even if you haven’t lived through one, you must have definitely heard or read about the big ones: the dot-com bubble in 2000 or the global financial crisis of 2008. Those events rocked the global economy, wiping out wealth and destabilising markets for years.

But behind these crashes lies something that’s often mentioned in the financial world: the Cyclically Adjusted Price-to-Earnings (CAPE) ratio, also known as Shiller’s P/E.

You see, back in 2000, right before the tech bubble burst, the CAPE ratio for the U.S. stock market hit a record high. It peaked again in 2007, right before the global financial crisis struck.

So, why are we talking about it today?

Because the CAPE ratio for Indian equities is today sitting at a hefty 43 times.¹ And that’s dangerously close to where it was before the 2008 crash. Add to that the fact that foreign institutional investors (FII) have pulled nearly $7 billion from Indian stocks in October alone.

So, should we start panicking? Is another market crash on the horizon?

Well, it’s complicated.  You can’t just look at one number and call it a day.

So, let’s break down what this CAPE ratio really means and how it fits into the bigger picture.

Even before we do that, let’s zoom in on the recent rise in Indian stock markets. The BSE Sensex and Nifty 50, India’s major stock indices, have been on a steady climb. And when stock prices go up way higher, they often outpace company earnings making stocks more expensive. By “expensive,” we’re referring to the price-to-earnings (P/E) ratio, which compares the price of a stock to the company’s earnings.²

Let’s say a company has a P/E ratio of 25. This simply means investors are willing to pay 25 times the company’s earnings for a share. It’s like paying ₹25 for something worth ₹1. A higher P/E ratio often means that people are hopeful about the company's future; therefore, they’re paying more than what’s actually worth today. But a higher P/E can also mean that the stocks are too expensive for what they're actually worth.

Right now, the Nifty 50 is trading at a P/E ratio of about 24.7, higher than its 10-year average of 23.4. Economists call this "irrational exuberance," meaning the market might be too confident, setting itself up for a fall.

Here’s an easy way to understand this: imagine you’re at a market with two identical items. One costs ₹100, the other ₹120. Why the difference? Let’s say the more expensive one is from a popular brand that everyone is talking about, so more people want it, even though both items are exactly the same.

This is what happens with stocks, too—demand, along with factors like investor sentiment, growth expectations, and market conditions, drives up the price, even if the value hasn’t really changed. For example, investors may be willing to pay more for a company if they believe it has strong future growth potential, even if its current earnings don't justify the high price.

And that’s what’s happening with markets today. Prices are rising faster than the actual earnings.

But the P/E ratio only tells us what’s happening in the short term. If we want a longer-term view, we turn to the CAPE ratio.

So, what’s the CAPE ratio, and how is it different?

Unlike the P/E ratio, which focuses on one year’s earnings, the CAPE ratio smooths things out by averaging earnings over the last ten years and adjusting them for inflation.³

It was popularised by Robert Shiller and John Campbell in 1988 as a way to smooth out short-term fluctuations and better assess a stock’s value over an entire business cycle.

To read it is simple: when the CAPE ratio is high, stocks are probably overpriced. When it’s low, they’re likely undervalued.

Sounds straightforward, right? Not quite. Because the CAPE ratio has its limitations too.

For one, it assumes that the stock market’s composition stays the same over time. But we know that markets evolve.

Just look at the U.S. stock market. Tech giants like Apple and Microsoft have grown massively over the past decade, yet the CAPE ratio still includes earnings data from when these companies were much smaller players.

And then there’s the issue of stock buybacks. Companies often buy back their own shares, which reduces the number of shares available and makes their earnings per share look better without actual growth. The CAPE ratio doesn’t take this into account, which means it can sometimes give a distorted view of the market.

And comparing CAPE ratios across countries can be misleading too. U.S. companies have experienced stronger earnings growth and more buybacks than Indian companies, so comparing them directly isn’t entirely fair.

Now, India’s CAPE ratio is high, which indicates that stocks here are expensive.

Why?

Well, for starters, India’s economy is growing faster than many other countries, making it an attractive destination for investors. It’s like a trendy new restaurant and everyone wants in.

And India’s growing weight in global indices like the MSCI is attracting more institutional money, driving up stock prices.

So, even though the CAPE ratio is high, there are reasons for it. India’s growth story is compelling, and investors are paying a premium for it.

But hey, the Indian stock market is also the second-most expensive in the world after Greece!

So, does that mean a crash is coming?

Not necessarily.

Critics argue that the CAPE ratio is based on historical data and doesn’t always predict future crashes. And as we know, the markets evolve, and past trends aren’t always a reliable guide.

Even Shiller, the creator of the CAPE ratio, started looking at another metric during the pandemic—the "Excess CAPE Yield."⁴ This compares stock earnings to returns on inflation-adjusted government bonds. If bond yields are low, investors are more willing to pay a premium for stocks, even if they look expensive.

So, where does that leave us and the Indian stock markets?

See, a high CAPE ratio might suggest that stocks are overpriced, but it’s just one piece of the puzzle.

And because the markets never move in isolation, you also need to consider other factors, like growth trends and how companies are returning value to shareholders. The market’s changing, and so should the tools we use to understand it.

Clearly, the CAPE ratio is more like a weather vane than a crystal ball. It signals trends, but it won’t predict the future.

The markets might drop. Or they might soar.

In the meantime, we’d do well to pay heed to what the legendary investor and fund manager Peter Lynch once said… “No one can predict with any certainty which way the next 1,000 points will be. Market fluctuations, while no means comfortable, are normal.” and… “You only need a few really big stocks in a lifetime to make a lot of money”.

So, for now, all we can do is stay alert and keep watching.

Until then…

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Story Sources: Economic Times [1]; Business Standard [2]; Firstlinks [3]; Financial Times[4]

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