In the investment world, financial indicators provide us with valuable tools to understand the context of the market (or of a particular stock). If, on the one hand, the PER tells us whether a stock is expensive or cheap, when applied to an index, it can also tell us the same thing for the index. Currently, stock markets and especially the U.S. markets look expensive if we look at some metrics such as the CAPE Ratio or forward price/earnings ratios. However, there are several reasons to consider this scenario with a broader perspective.
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ToggleU.S. markets look expensive
The CAPE Ratio (Cyclically Adjusted Price/Earnings Ratio), developed by Robert Shiller, is currently at 38 times. Historically, these levels have coincided with times of overvaluation, such as the bubbles of 1929 (where it reached the level of 32.6) and 2000 (peak level of 43.5). This suggests that U.S. stocks are expensive compared to their cyclically adjusted earnings, and clearly above the historical average of 17.6.
The Forward P/E Ratio also gives us clues about the situation. As we see in the chart above, the S&P 500 ratio currently exceeds 22 times, while international indices such as the MSCI World ex-US are at much lower levels at below 15 times. This disparity reinforces the perception that the US is leading valuations, but other markets are at significantly lower levels.
There are other indices, for example, those of small-cap companies, which are even below their historical average.
One explanation: Historically low interest rates
Although interest rates rebounded during 2023 and part of 2024, we remain in a relatively low interest rate environment from a historical perspective. In a historically low interest rate environment, the opportunity cost of investing in equities decreases. This means that in the absence of investment alternatives with attractive returns and lower risk, investors tend to assign higher valuations to equities. Low rates reduce the discount rate applied to future cash flows, thus raising the present value of companies and, consequently, the CAPE Ratio. This dynamic can prolong elevated valuation levels for longer than historical precedents would suggest. Furthermore, if real rather than nominal yields were compared in the chart above, an even more negative correlation between the two factors could be observed.
Another explanation: a new technological paradigm?
Despite the high valuations, this situation is not necessarily an immediate warning sign. The irruption of new technological paradigms, such as artificial intelligence (AI), is transforming the global economy and concentrating a significant part of the growth in leading companies in the sector. For many, we are in the early stages of a technological revolution that could be the most transformative and productive breakthrough of our generation.
AI has the potential to significantly increase productivity, a key driver of long-term economic growth. Most interestingly, this growth could be achieved without generating inflationary pressures, justifying higher valuations in markets such as the U.S., where technology giants are leading this transformation.
A clear example is the massive investment in data infrastructure and AI-specific chips, dominated by the so-called “Magnificent Seven” (Apple, Amazon, Microsoft, Meta, Nvidia, Alphabet and Tesla). While this represents great long-term potential, it also carries significant risks due to the high concentration in a few companies and uncertainty about how this technology will evolve in the future.
While some see it as the start of a new bubble, others see an unprecedented opportunity. It is probably wisest to adopt a middle ground position, taking into account both the opportunities and the risks.
P/E and CAPE ratios: tools for thinking, not for prediction
It is important to remember that the CAPE Ratio is not a good indicator of the best time to enter the market. Historically, although high CAPE levels have preceded major corrections, we have also seen prolonged periods where markets have continued to rise despite high valuations. In addition, high P/Es or CAPEs may be anticipating periods of high growth or significant change, as mentioned above. This underlines the importance of not making hasty decisions based on this indicator alone.
Opportunities in other markets
In contrast to the United States, other markets such as the European or emerging markets show much lower valuation ratios. This could offer better opportunities for investors looking to diversify and optimize their portfolios.
The Forward P/E Ratio of the MSCI World ex-US, for example, as seen in the chart above, is significantly below, indicating a better balance between risk and potential return in markets outside the US.
Other indices, as seen in the chart below, have more moderate P/E ratios, and are in line with historical averages.
Conclusion: Diversification and customized planning
In an environment of high valuations in the United States and opportunities in other markets, the key for investors is:
- Diversify: Avoid concentration in one asset class or market. Although those that are overvalued may suffer some adjustment, other assets will compensate.
- Stick to your plan(s): Avoid impulsive decisions and base your strategy on clear personal and financial objectives.
- Adjust or revise your investment plan: If your circumstances change or if you feel uncomfortable, make sure your portfolios reflect both the objectives and risk tolerance of each investor.
At inbestMe we believe in the importance of a diversified and customized approach for each investor based on their objectives and horizons rather than on the market situation. Our platform helps you build portfolios tailored to your needs and objectives, combining, diversifying across different global asset classes to maximize your chances of long-term success.
If your horizons are long term, the asset that will help you beat inflation will be equities, and our index fund (or ETF) portfolios should have a medium or high proportion of equities (depending on your risk profile).
But if your objectives are short-term, our bond portfolios or target portfolios may be more suitable for you.
However, if what you want is to get a return on your savings or emergency fund, you should not take risks and the savings portfolio will be the best option.