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The 2013 stock market rally was largely driven by rising valuation multiples. Weak economic growth, coupled with healthy profit margins, meant business fundamentals such as revenues and earnings barely budged as stock prices advanced. Today, some absolute valuation measures reflect varying degrees of overvaluation in domestic stocks. Should investors be reducing U.S. equity exposure as a result?

The cyclically adjusted price-to-earnings ratio (CAPE, or P/E 10 Ratio) is among the more talked-about valuation metrics lately because it shows that stocks are more expensive today than during most of the last century. Some investors are expressing concern as there have been past occasions when CAPE reached levels similar to today and markets weakened materially in the periods that followed.

To calculate CAPE, one must take annual earnings per share of an index over the past 10 years, adjust for inflation to arrive at real earnings, compute the average for the 10-year period, and then divide the current index price by the earnings figure. The idea behind CAPE is to show the relationship between the current index price and a smoothed version of real earnings per share. By using average real earnings over a decade in the denominator, the ratio seeks to remove the impact of variations in profit margins that occur during a business cycle. The current CAPE for the S&P 500 is about 25.

Analyses of CAPE as an indicator of market returns show that it can be useful over long time horizons such as a decade or more, although is not a good predictor over short-term periods of a year or a few years. The limited near-term predictive power is not just a weakness of CAPE, but of valuation metrics more broadly. By themselves, valuations are not an ideal forecaster of future market performance. Numerous economic variables and market sentiment indicators must also be considered alongside valuations in order to establish a well-rounded outlook.

While history shows that expensive markets revert to the mean sooner or later, specific to the current environment, the weight of evidence from the many indicators we monitor is consistent historically with mid-to-high single-digit return environments. Our view is that prices are not overextended. We think the most attractive time to be heavily overweight U.S. stocks has likely passed, but caution against completely eliminating domestic exposure at this juncture. Stocks could continue to move higher from present levels if a pick-up in economic growth fuels improvement in company fundamentals, and/or if the market mood is such that investors are willing to pay even higher multiples.

A look back at market environments of the late 1990s/early 2000s and the post recessionary period from 2003 to 2008 helps illustrate this point. In both instances, if investors were basing decisions on CAPE and opted to avoid domestic stocks when the ratio was above a certain threshold (e.g. at or above 25) a lack of U.S. equity exposure would have resulted in substantial missed gains as sell signals emerged well before the market topped.

For example, CAPE breached 25 during late 1995, but the U.S. market did not hit its peak until August 2000. If investors sold all of their domestic holdings in the mid-1990s, they would have failed to capture any subsequent upside. The S&P 500 provided annualized returns of 23.3% from January 1996 through August 2000.

A combination of skill and luck might have led investors back into the U.S. market as stocks were bottoming in 2002. From there, however, it was not long before CAPE hit 25 again during the third quarter of 2003. The ratio then stagnated in the mid-20s range from 2003 until late 2008, a period during which the S&P 500 provided annualized returns of 7.6%. Had investors opted to sell in 2003, these gains would also have been missed.

No one can time the market perfectly so investors often turn to metrics like CAPE to help give a sense of conditions in the market cycle. The challenge is that CAPE lacks accuracy in short-term forecasts and does not reflect valuations of certain market segments or individual stocks. Many strong U.S. companies are trading at much more attractive valuations than the broad market today, and could represent compelling long-term investment opportunities. We believe that too much focus on singular metrics like CAPE can stand in the way of capturing these opportunities and participating in the upside.

Disclaimer: The S&P 500 Total Return Index (S&P 500) is an unmanaged, capitalization-weighted measure of 500 widely held common stocks listed on the New York Stock Exchange, American Stock Exchange, and the Over-the-Counter market. The Index returns assume daily reinvestment of dividends and do not reflect any fees or expenses. Index returns provided by Bloomberg. S&P Dow Jones Indices LLC, a subsidiary of the McGraw Hill Financial, Inc., is the publisher of various index based data products and services and has licensed certain of its products and services for use by Manning & Napier. All such content Copyright © 2014 by S&P Dow Jones Indices LLC and/or its affiliates. All rights reserved. Neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and none of these parties shall have any liability for any errors, omissions, or interruptions of any index or the data included therein.

iReflects S&P 500 annualized total return from 6/30/2003 through 6/30/2008

Source: Cyclically Adjusted Price To Earnings: Are U.S. Stocks Overvalued?