So what? Really? The question should be, What now? I like ratios. Because, not many things in investing are absolute. That’s why PPP adjusted GDP is more meaningful than GDP. PE ratio is one metric that many pros and non-pros use before investing. But more interesting than ratios is their historic variations. So, I looked at the historic values of PE, Book-to-Price, and CAPE ratios of S&P 500. The charts are interesting and I concluded that the risk-reward is not what I’m used to and consequently, I’m reducing my exposure.
Firstly, the Book-to-Price is 5.3X and it’s the highest ever. Even during dotcom era, it was only 5.1X. You may say, so what, but I say, not for me.
Secondly, the PE ratio for S&P500 is at 22.5X while it was 25X during dotcom. In other words, it’s in the 95th percentile since 1988. Again, the message for me is, reduce exposure. So, I did.
Thirdly, CAPE is as high as it was during dotcom. I don’t like that either. For me, it’s one more validation for my decision to reduce exposure.
One more ratio that’s not used often but I find helpful is Buffett’s indicator. It’s the ratio of total US stock market cap against the GDP. “If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% — as it did in 1999 and a part of 2000 — you are playing with fire,” he said once and I like it. Today, it’s at 213%, much higher than dotcom levels.
So, I’m putting my trader hat on for a few weeks. When I’m in doubt, I tend to morph into a trader. This approach has worked for me. But you may say, the earning may grow into the high valuations and lower these ratios. It very well could happen, and you may get your ‘I told you so’ moment! However, I don’t mind giving up big profits for my sleep. But never the other way around! I really like my sleep people.
