The Danger of Trading Stocks Based on Valuation

By: Wayne Duggan

The S&P 500 has been cutting through all-time highs in 2021 like a hot knife through butter. As each new milestone falls, investors are wondering just how high the stock market’s valuation can go. Unfortunately, there’s no certain way to know exactly when a market is reaching the top or bottom of a cycle.

There are countless fundamental valuation metrics out there that give investors an idea of how overvalued or undervalued the market may be at any given time. But those metrics are often terrible predictors of the timing of a market reversal.

Robert Shiller’s CAPE Ratio
One person that is an expert in the dynamics and psychology of stock market bubbles is Yale economist and Nobel laureate Robert Shiller. Shiller famously released his best-selling book “Irrational Exuberance” in 2000 at the height of the dot-com bubble. On several occasions from 2003 to 2007, Shiller published papers about the bubble in the U.S. housing market as well.

In “Irrational Exuberance,” Shiller frequently references a fundamental valuation metric called the cyclically adjusted price-to-earnings ratio, or CAPE. CAPE is a tweak of the common price-to-earnings ratio, but it includes 10 years’ worth of earnings to smooth out any short-term fluctuations.

Going back more than 100 years, the S&P 500 has averaged a CAPE ratio of 16.8. Today, the S&P 500 CAPE ratio is 38.7 — more than double its average level. However, traders that see this extreme valuation should think twice about rushing to sell or short sell the stock market.

It’s All About Perspective
Taking a look back at the dot-com bubble in 2020, the S&P 500 CAPE ratio hit 32 in July 1997. That level represented roughly double its long-term average. Historically, the S&P 500 was extremely overvalued trading at around the 900 level at the time. 

Traders who shorted or sold stocks at that time based on the market’s valuation spent the next 3 years getting absolutely crushed. On March 24, 2000, the S&P 500 finally hit an intraday peak of 1,552.87, about a 72% gain from that 900 level that seemed so pricey back in 1997. That 32 CAPE ratio in 1997 made the market appear insanely overvalued, yet the S&P 500’s CAPE didn’t actually peak until it surpassed 44 in December 1999.

Valuation Is a Terrible Timing Mechanism
Valuation metrics like the CAPE ratio are an excellent way for long-term investors to assess how expensive or cheap a stock or a market is relative to its historical levels. But there’s an old trading adage about markets that become irrationally priced.

“The market can stay irrational longer than you can stay solvent,” is attributed to economist John Maynard Keynes, and it still holds true to this day.

Just because a stock is extremely overvalued doesn’t mean it can’t double or triple to an even wilder valuation before its momentum runs out. Even if a bearish valuation thesis is eventually proven right months or years down the line, an ill-timed short trade in a red-hot market can blow up your trading account before you ever even get the chance to say, “I told you so.”

Understanding valuation metrics is an important part of getting the full picture of an investment. But be very careful trying to time trades based on overvaluation or undervaluation alone.

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