Have stock prices lost touch with reality?

Robert Shiller’s cyclically-adjusted PE (or CAPE) is at a similar level to the 1929 peak before the greatest crash in US history. CAPE uses a 10-year average of inflation-adjusted earnings in order to smooth out fluctuations in earnings. The current reading of 29.2 is almost double the low during the 2008 global financial crisis (GFC).

S&P 500

We use a different approach. Rather than smoothing earnings with a moving average, we use highest trailing earnings as the best indication of future earnings potential. Earnings may fall during a recession but stock prices tend to fall by less, in expectation of a recovery. Our projected value for the end of Q4 is based on highest trailing 12 months earnings at Q1 of 2022. At 20.16, the PE is higher than 1929 and 1987 peaks, which preceded major crashes, but still much lower than the Dotcom bubble.

S&P 500

Forward price-earnings ratio is more reasonable at 17.91.

S&P 500

But S&P earnings forecasts seem optimistic, with no indication of a recession in 2023.

S&P 500 Historic Earnings & Forecast Earnings

Declining real sales growth, in the first half of 2022, suggests that profit margins will come under pressure, with both earnings and multiples declining in the next 12 months.

S&P 500 Real Sales Growth

Shifting from earnings to a wider perspective, price-to-sales for the S&P 500 avoids distortion caused by fluctuating profit margins. Projected to rise to 2.30 in Q4 (based on the current S&P price and Q3 sales), prices are similarly elevated compared to the long-term average of 1.68.

S&P 500/Sales

Price to book value, estimated at 4.01 for Q4, shows a similar rise compared to a long-term average of 3.07.

S&P 500/Book Value

Warren Buffett’s favorite indicator of market pricing compares stock market capitalization to GDP, eliminating distortions from fluctuating profit margins and stock buybacks. The Q3 value of 2.0 is way above the long-term average of 1.03, suggesting that stocks are way over-priced.

US Stock Market Capitalization/GDP


Data is a lot more difficult to obtain for the ASX, but the ratio of market cap to GDP (Buffett’s indicator) is a lot more modest, at 0.96, indicating prices are close to fair value.

ASX Stock Market Capitalization/GDP


The chart below shows how rising US liquidity (black) fueled rising stock prices as reflected by the ratio of market cap to GDP (blue). The steep rise in the money stock (M2 excluding time deposits) after the 2008 GFC, created a scarcity of investment-grade assets, driving down interest rates and driving up stock prices.

US Stock Market Capitalization & M2/GDP

Central banks are now shrinking liquidity, in an attempt to tame inflation, and stock prices are likely to fall.

We estimate that US stocks are likely to fall between 30% and 50% if there is a recession next year. Australian stock prices are a lot closer to fair value and only likely to fall 10% to 20% in the event of a recession.

In our view a recession is almost inevitable in 2023 as the Fed cannot inject liquidity to create a soft landing — as it has done repeatedly in recent times — because of the threat of inflation.


  • The graphs of Robert Shillers CAPE, S&P 500 real sales growth, and S&P 500 price-to-book value are from multpl.com
  • Sales and earnings for the S&P 500 are from spglobal.com
  • All other US data is from FRED at stlouisfed.org
  • Market cap for the ASX is from asx.com.au while GDP is from the RBA.