The cyclically adjusted P/E (CAPE) has a current extreme ratio of 27.7 gives a worrying sign for future returns versus bonds according to many leading academics. This important market indicator has hit such extreme levels in the last month of 2016, that such levels haven’t been seen since the plunges in 1929, 2000 and 2008, all of which preceded financial crises.
This latest drop has only stood over 27 three times before, during the 1929 mania, the 2000 tech mania and 2007 housing/stock bubble.
What is CAPE?
CAPE is a price earnings ratio based on average inflation-adjusted earnings of the past decade. It was designed in 1988 and its creators, professors John Y. Campbell and Robert Shiller won the Nobel Prize in 1993 for thinking up the concept.
While it is an excellent idea, there are some that believe it has a key flaw and therefore cannot always be viewed as a highly accurate predictor. This is because of changes made by the S&P due to the Financial Accounting Standards Board changing the definition of GAAP earnings. So, even though it is at worrying levels, it doesn’t mean a financial crisis is definitely on the way (it breached 27 in 1997 previously, for example).
Trump’s Economic Agenda
Before the US election there were many predicting that the US dollar and the stock market would crash if Trump was victorious. Over a month on however, though there may have been a slight impact at the start, it has been nowhere near as bad as many predictions assumed. In fact, the S&P 500 is reaching all-time highs in anticipation of Donald Trump’s economic agenda.
Still, experts believe that even if the market’s earnings increase by 10% under Trump’s fresh economic policies, it would have little difference. Overvaluation would still exist and the same problems remain, with another financial crisis a possibility.
Banking Sector Issues
In many advanced economies the banking systems are a lot larger than they should be, when compared against their respective economy. There are currently a number of areas in which banking stress is evident across the globe that seem to be teetering on the edge of a cliff.
For example, in Italy there are around €360 billion worth of non-performing loans, which make up about 20% of their GDP. These make up about 15% of all banking loans, compared to just 5% in the USA during the 2008 banking crisis, suggesting another crisis could be on the cards unless something is done soon.
Protecting Yourself in the Event of Another Crisis
As investors, savers and simply those looking after their financial futures, there are various things you can do. We have not quite reached the point of having to withdraw all the money from our accounts and many banks across the world continue to perform well. The key is keeping your ear to the ground with what is happening and looking into low-risk investment strategies such as gold. Hopefully these indicators will be wrong as they have been in the past and this time and another financial crisis is not on the way, but if it is then it is essential to be prepared.
