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Why stocks may have become more expensive in 2022

On one measure at least. The sharp fall in US stocks this year has lowered the historical and forward price-earnings ratios and also Robert Shiller’s cyclically-adjusted price-earnings ratio (CAPE). But arguably a better measure than all of these – and the one now preferred by Shiller himself - shows stocks becoming more expensive in 2022, not less. The reason is that bond yields have risen by more than the earnings yield. Lets look at the calculations.


The CAPE, developed by Nobel-prize winning economist Robert Shiller in the late 1980s has long been the preferred valuation metric for many long-term investors. By comparing the average of 10 years of historical earnings with the current index level, it avoids sometimes misleading results from using just one year. However, the US CAPE has been persistently high in the 21st century, which is often attributed simply to interest rates being so low.

Shiller responded by developing the Excess CAPE yield (ECY) as an alternative measure which includes rates in the calculation. The ECY takes the inverse of the CAPE to get an earnings yield and then subtracts the real bond yield. So, for example, the US CAPE yield stands at about 31.6 today (based on an S&P500 level of 4000) and using the last 10 years of earnings. Take the inverse and we get an earnings yield of 3.2%. With the last 10 years of CPI inflation averaging 2.3% and 10-year bond yields of 2.9% we get a real yield of 0.6%. We subtract that from the earning yield to give an ECY of 2.6%.

Now compare with end-2021. At end-2021 the US CAPE was at 38.3, giving an earnings yield of 2.6%. But the 10-year bond yield was only 1.5% and average inflation in the prior 10 years was 2.1%. (Recent very high inflation has been enough to move the dial on this long-term average in just a few months). So at that time the real bond yield was -0.6% giving an ECY of 3.2%. Higher means cheaper for the ECY (the opposite of the CAPE ratio). So, the ECY has gone down, meaning stocks are more expensive.

Note that Shiller uses historical inflation to calculate the real yield because he wants a consistent approach over his 140-year data set (see Shiller website). But we can also consider the real yield on inflation-indexed bonds (TIPS). It turns out that this has also moved up 1.2% over the same period this year, though the levels are slightly different (-1% to 0.2%). Either way then the ECY shows stocks becoming more expensive this year.

Now some good news

The good news is that, although the ECY shows stocks becoming more expensive they are not nearly as expensive as at past market peaks such as 1929 or 2000 or even the mid-to-late 1960s when the ECY fell to zero or below. Nor, at 2.6% is today’s ECY as expensive as in 2018 when it fell to 1.6%. So the bottom line is that stocks have indeed become more expensive relative to bonds this year but nevertheless are not wildly expensive compared with history.


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