Professor Robert Shiller's CAPE (Cyclically Adjusted Price-to-Earnings) ratio, also known as the Shiller PE ratio, is a widely followed valuation metric for assessing the long-term valuation of the stock market. It differs from the traditional P/E ratio by using a longer-term average of earnings to smooth out the impact of economic cycles and provide a more stable measure of valuation.

The CAPE ratio provides a great historical context for stock market valuations, allowing investors to see how current valuations compare to historical averages. Let's take a look at the following chart of the CAPE ratio using stock market data since 1871.

The current CAPE ratio sits at 30.8 for September 2023. This is a preliniary reading as all data inputs are not finalized yet.  The CAPE ratio has declined from a very high reading of 38.6 in November 2021.  This reading coincided with the top in the Nasdaq and just prior to the peak in the Dow Jones Industrial Average and S&P 500 Index in January 2022.  You will notice that this peak in valuation was higher than 1929 and second only to the extreme achieved in the Dotcom bubble of 1999-2000.  2021 had its share of craziness and extreme market activity creating a bubble for the ages.

One of the key insights from the CAPE ratio is the concept of mean reversion. Historically, when the CAPE ratio has been high (indicating overvaluation), subsequent returns have tended to be lower, and when it has been low (indicating undervaluation), subsequent returns have tended to be higher.

Coming down from the 2021 peak, I believe we are in the process of stair stepping our way down. We could very easily do something like what occurred between 1966 and 1982 when the stock market basically went sideways for 16 years with wild swings. Or we could take the elevator down like after 1929 and 1999.  How low? No one knows.  But everything moves in cycles.  Just look at what has happened in  the bond market recently.

There is something else that I hadn't noticed before.  Look at the CAPE ratio readings in 1921 and 1932.  The stock market went lower in 1932 but the CAPE ratio provided a bullish divergence indicating a long-term bottom.  And a similar thing occurred with the CAPE readings of 12/1999 and 11/2021.  Stock market in 2021 was much higher than 1999/2000 but the CAPE ratios provide a long-term bearish divergence indicating a possible long-term peak.  

Now the CAPE ratio is not a precise timing tool for short-term market movements. High or low CAPE ratios do not necessarily predict immediate market crashes or rallies. Markets can remain overvalued or undervalued for extended periods, and other factors, such as interest rates and economic conditions, also play a significant role.  

But CAPE ratios do indeed provide perspective on where the market sits compared to previous times in history of overvaluation and undervaluation.  The CAPE ratio is saying this stock market is still extremely overvalued.

Does the timing of interest rate hikes and cuts impact the the stock market? Do cuts in interest rates then lead to a stock market peak and subsequent decline? Or are cuts just a confirmation of the direction the stock market is already in? Lets take a look at the last 25 years.

1998 - 2003

In 1998. the Fed cut interest rates in reaction to the Russian currency crisis. They cut three times. The lowest weekly close on the SPX occurred the week of August 30, 1998 before the first cut on September 29, 1998. The third and last cut was on November 17, 1998. 

The Fed resumed raising rates in mid-1999 starting with +25 bps on June 30, 1999. The SPX peaked the week of March 19, 2000. The Fed's 5th rate hike of +25 bps occurred on March 21, 2000 to be followed by yet another rate hike on May 16, 2000 of +50 bps. 

The Fed did not cut rates until January 3, 2001 where they cut -50 bps. The SPX had been in decline for 9 months. It is also interesting to note that the SPX bottomed the week of October 6, 2002 before the last 2 rates cuts in November 2002 and June 2003 for a total of 13 rate cuts.

2004 - 2009

The Fed raised interest rates +25 bps 17 times from June 30, 2004 to June 29, 2006. The market kept pusing higher into 2007. The Fed decided to cut rates by -50 bps on September 18, 2007. The SPX peaked the week of October 7, 2007, about 3 weeks later. So as opposed to the peak in 2000, this time the market peaked after the first rate cut. 

The intensity of the crisis was evidenced by the 10 rate cuts bringing interest rates to zero with the final cut of one full percentage point occurring on Dec. 16, 2008.  The market bottomed the week of March 1, 2009, 11 weeks after the last cut.

2015 - 2020

The Fed kept interest rates at zero for the next 7 years in what became know as the Zero Interest Rate Policy (ZIRP). Beginning on Dec. 17, 2015 they rasied rates by +25bps for the first of 9 straight raises over 3 years. 

The first cut of -25bps occurred on Aug. 1, 2019 followed by 2 more cuts of the same size until the COVID panic of 2020 hit. They then cut by -150 bps over a 2 week period in March 2020. Interest rates were now back to zero. 2020 was a minor peak in the SPX, not the end of the primary wave up from March 2009. The peak in the SPX occurred the week of January 2, 2022.

The Fed did not start raising rates until 10 weeks after the peak and have now raised them 11 times. This time does seem to be different though. In prior cycles the Fed was raising while the market was increasing. So will the 2022 peak in the market hold as we expect? When the market turns down it will be because something different is indeed happening and the Fed will follow suit with rate cuts that they justify because the data changed.  

"Whoever wishes to foresee the future must consult the past; for human events ever resemble those of preceding times...this arises from the fact that they are produced by men who have been, and ever will be, animated by the same passions."   - Machiavelli