This ratio is often seen as a bellwether for the U.S. stock market… but here’s what it’s missing.

From the desk of Miles Everson:

Investing is an activity that has helped many achieve financial freedom and build prosperous lives for decades.

That’s why every Wednesday, I talk about investing in the hopes of helping you build wealth through this activity.

In today’s  “The Independent Investor,”  I’ll talk about one of the mainstream financial media’s favorite economic warning signs… and why you can’t totally rely on it because of a glaring flaw.

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This ratio is often seen as a bellwether for the U.S. stock market… but here’s what it’s missing.

The mainstream financial media is doubling down on all of its favorite economic “panic” buttons today.

It’s no secret today’s valuations in the U.S. stock market are high, especially when the market’s price-to-earnings ratio (P/E) stands at around 24x—above the 20x long-term average.

Meanwhile, the Buffett Indicator, which is used to compare the total market cap of U.S. equities with the country’s gross domestic product (GDP), hit an all-time high of 225%, higher than the 70% to 80% range legendary investor Warren Buffett argues is ideal for investing.

There’s also another metric investors rely on: The Shiller cyclically adjusted price-to-earnings (CAPE) ratio, which just crossed 40, a level that was last observed during the dot-com bubble of the late 90s.

These metrics, especially the Shiller CAPE ratio, have triggered bearish sentiment among investors and observers. Some economists are even predicting a 40% nosedive for the S&P 500 index. Moreover, pundits are suggesting that we’re in one of the most  overvalued  markets of all time.

Taken at face value, today’s market conditions look extreme, especially when it’s taken into account that the Shilller CAPE ratio has only crossed 30 a few times since 1871, each time preceding a major pullback.

However, there’s more to this than meets the eye.

You see, while the ratio can be a warning sign, it has some caveats… and it all traces back to  as-reported financials .

The Shilller Cape ratio has been built up as a better version of the standard P/E, as it smooths out cyclical earnings by averaging the past 10 years, adjusted for inflation. This essentially makes it less susceptible to boom and bust cycles. 

Theoretically, it  should  offer a clearer long-term view of market valuations. And according to  Professor Joel Litman , Chairman and CEO of  Valens Research  and Chief Investment Officer of  Altimetry Financial Research, the ratio has done a decent job of being a market indicator.

The CAPE ratio flashed warning signs ahead of both the Great Depression and the dot-com bubble.

However…

Professor Litman also points out a glaring problem: The Shiller Cape ratio  still relies on as-reported earnings.

As a result, it inherits the  flaws  found in generally accepted accounting principles (GAAP), especially its tendency to punish companies with large non-cash expenses. 

Economist Jeremy Siegel has long warned about this flaw. In a paper published in 2016, he showed that Shiller CAPE’s overvaluation signal shrinks when metrics that aim to measure cash earnings are used.

Back then, the CAPE ratio was 54.6% above its historical average. However, when it’s recalculated using S&P's operating earnings, that number fell to 40%. 

Moreover, when using the  U.S. Bureau of Economic Analysis' national income and product accounts (NIPA), it fell to just 19% overvalued.

(NIPA attempts to measure cash-based operating earnings as accurately as possible, ignoring all non-cash expenses.)

It's not just a one-off. Time and again, the Shiller CAPE ratio has come in far above versions that look at cash earnings, as shown in the table below.

As seen above, this massive difference is a sign that investors shouldn’t take headline numbers at face value. When Siegel’s findings are taken into account, today’s market may be expensive,  but not wildly so.

Depending on which adjusted metric is used, valuations can be overstated by somewhere between 10% and 40%... and the bigger the difference between GAAP and cash earnings, the bigger the rift between each ratio and reality.

Disclaimer: We’re not denying that valuations are high; we’re just saying that before you panic over today’s Shiller CAPE ratio, it’s worth keeping in mind this number is distorted by GAAP.

As a result, it doesn’t accurately show what’s happening to today’s businesses and the overall state of the U.S. stock market.

According to Professor Litman, interest rates are falling, helping accelerate dealmaking and corporate profits.

Said another way, today’s market isn’t cheap, but it’s not priced to perfection either… and this means you don’t have to panic or suddenly adopt an extremely bearish mindset when investing.

Hope you’ve found this week’s insights interesting and helpful.

Stay tuned for next Wednesday’s The Independent Investor!

The investment world thrives on stories—bold bets, disruptive ideas, and fortunes made (or lost) on what once seemed like a shot in the dark.

Learn more about  the four simple rules for VC success  in next week’s article!