This Famous Method of Valuing Stocks Is Pointing Toward Some Rough Years Ahead

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  Stocks and Investing on Thu, Nov 06th, 2025 by The Wall Street Journal

The P/E Ratio as a Historical Indicator

At the heart of the article is the observation that the P/E ratio of the S&P 500 has historically been a reliable leading indicator of future returns. The ratio compares the market price of a share to the earnings it generates. When the ratio rises above its long‑term average, it suggests that investors are paying more for each dollar of earnings, often indicating that valuations are inflated. Conversely, a low ratio can signal that the market is undervalued and potentially primed for a rally.

The author references the work of Robert Shiller, the Nobel laureate who popularized the cyclically adjusted price‑to‑earnings (CAPE) ratio. Shiller’s CAPE smooths earnings over ten years and adjusts for inflation, providing a more stable gauge than a single‑year P/E. A link embedded in the article directs readers to Shiller’s website, where the historical CAPE data for the S&P 500 can be viewed. The graph shows that the current CAPE is around 23, which is well above the 15‑year average of 15. Shiller has repeatedly noted that such levels often precede a 5‑year decline in equity returns.

The Current Landscape

The article underscores that the S&P 500’s 2024 P/E ratio sits near 22, with the CAPE ratio hovering around 23. These numbers are striking because, after the 2008–2009 financial crisis and the pandemic‑era rally, the market’s valuations have remained stubbornly high. While the market has delivered robust returns over the past decade, the P/E ratio’s climb raises the specter of a correction. The author cites a recent research paper that finds a strong inverse relationship between the CAPE ratio and subsequent 5‑year returns, a relationship that has persisted even through the most recent market upheavals.

How the Metric Works

The article explains that the P/E ratio is a snapshot of the market’s expectations for future earnings. A high ratio may reflect optimism about corporate growth, but it can also mean that the market has priced in a lot of earnings growth that may not materialize. The author uses a simple analogy: if the market is buying a house based on a projected future rent that may never materialize, the purchase price is vulnerable if the rent falls short. The same principle applies to stocks.

The piece also touches on the mechanics of the CAPE ratio. Because it averages earnings over ten years, it smooths out earnings volatility and provides a clearer picture of long‑term valuation. This smoothing means that the CAPE is less sensitive to short‑term earnings spikes or troughs, making it a more reliable gauge of fundamental value. The embedded link to Shiller’s dataset allows readers to see how the CAPE ratio has moved over the last 50 years, including the peaks following the dot‑com bubble, the 2008 crisis, and the recent 2020 rally.

Implications for Investors

The article does not provide investment advice, but it offers a candid assessment of what the elevated P/E and CAPE ratios mean for investors. A “rough” period ahead could involve tighter markets, lower equity returns, and higher volatility. The author suggests that investors might consider a more cautious stance: diversifying holdings, rebalancing portfolios, and reviewing risk tolerance. They may also think about incorporating defensive assets such as bonds or dividend‑paying stocks, which historically perform better during downturns.

In addition, the article highlights that a high P/E ratio often coincides with a narrowing of the earnings yield (the reciprocal of the P/E). The current earnings yield sits at roughly 4.5%, a modest level that has been above the 4% threshold that many investors use as a benchmark for undervaluation. As the earnings yield erodes further, the market’s capacity to sustain high prices diminishes.

A Call for Vigilance

The overall tone of the article is one of sober reflection rather than panic. By revisiting the fundamentals of the P/E ratio and referencing Shiller’s CAPE data, the piece illustrates why many academics and seasoned investors view the current market conditions as a cautionary tale. The author stresses that while markets are inherently cyclical, the historical evidence suggests that elevated valuations do not last forever.

Readers are left with the understanding that the famous method of valuing stocks—simple, widely understood, and historically predictive—now signals that investors may need to brace for a more turbulent market environment. The article’s use of clear charts, historical context, and accessible language serves as a useful primer for anyone seeking to understand how valuation metrics can provide early warning signs of future market performance.