What a Rare Market Pattern Signals for Investors

The S&P 500 (SNPINDEX: ^GSPC) is trading at one of its highest valuations on record based on the Shiller cyclically adjusted price-to-earnings (CAPE) ratio, which stood at 41.7 on Sept. 10. Readings above 40 have occurred only once before, during the dot-com boom of 1999-2000.

Image source: Getty Images.

Missed Nvidia in 2009? This Rare Signal Is Flashing Again. In 2009, a "Double Down" signal flashed for a little-known chipmaker called Nvidia. For the first time in years, that same "Total Conviction" signal is flashing for a company 1/100th the size of Nvidia. Continue »

This may sound like a warning that a market crash is approaching. However, the CAPE ratio is more useful for estimating long-term return potential than for predicting when stocks will fall.

A high valuation does not mean stocks are about to fall

The CAPE ratio compares the inflation-adjusted value of the S&P 500 with average inflation-adjusted earnings over the previous 10 years. Using a 10-year earnings average helps reduce the impact of short-term swings in corporate profits and provides a longer-term view of market valuation.

The current CAPE ratio is close to the record 44.19 reached in December 1999. However, it had already moved above 40 in January 1999 and remained above that level through September 2000. A CAPE ratio above 40 is better viewed as a sign of stretched long-term valuation than as a reliable signal that stocks are close to a near-term peak.

According to Vanguard, valuation levels have limited utility for forecasting short-term market returns. They become more useful at periods approaching 10 years:.

Why the CAPE ratio and forward P/E are telling different stories

The S&P 500 is valued at 19.8 times forward earnings, down from roughly 22.2 in early January. Even with the index close to record levels, its valuation based on expected earnings has come down.

Strong earnings may have helped market valuations. According to FactSet, the S&P 500's third-quarter bottom-up earnings-per-share (EPS) estimate increased 1.2% during July and August. FactSet defines bottom-up EPS as the median of EPS estimates across all companies in the index. On the other hand, over the past five years, this estimate has declined by an average of 1.7% during the first two months of a quarter.

Analysts also raised the S&P 500's full-year bottom-up EPS estimate by 6.1%, from $340.49 to $361.38, between June 30 and Aug. 31. Seven of the 11 S&P 500 sectors saw their full-year estimates increase over the same period.

So the CAPE ratio and forward price-to-earnings (P/E) can send different signals. Forward P/E uses expected earnings for the coming year, so stronger profit forecasts can quickly reduce the multiple even if stock prices remain high. The CAPE ratio moves more slowly because it averages 10 years of inflation-adjusted earnings.

What this rare pattern signals for investors

Today's elevated valuations suggest that long-term returns may be lower than investors have historically earned.

In fact, according to Vanguard Capital Markets Model forecasts, annualized U.S. equity returns are expected to be in the range of 4.2% to 6.2% over the next 10 years. This is lower than the previous estimate of 4.9% to 6.9%, as U.S. equity valuations have become more stretched.

Investors should not avoid stocks. Strong earnings could continue supporting the market for years. However, unusually high starting valuations leave less room for earnings disappointments and make the price investors pay increasingly important.

Manali Pradhan, CFA has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.