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A Reversion to the Mean is Coming...

The stock market is no longer cheap.


The single best predictor of stock market performance is the cyclically adjusted price-to-earnings ratio or CAPE ratio. Most investors price a company based on its current Price to Earnings or P/E ratio. Essentially what you’re doing is comparing the price of the company today to its ability to produce earnings (cash).


However, corporate earnings are heavily influenced by the business cycle.


Typically the US experiences a boom and bust once every ten years or so. As such, companies will naturally have higher P/E’s at some points and lower P/E’s at other. This is based solely on the business cycle and nothing else.


CAPE adjusts for this by measuring the price of stocks against the average of ten years’ worth of earnings, adjusted for inflation. By doing this, it presents you with a clearer, more objective picture of a company’s ability to produce cash in any economic environment.


We have mentioned before that CAPE is the single most important metric for long-term investors. I wasn’t saying that for impact.


Based on a study completed Vanguard, CAPE was the single best metric for measuring future stock returns. Indeed, CAPE outperformed


1.     P/E ratios

2.     Government Debt/ GDP

3.     Dividend yield

4.     The Fed Model,


…and many other metrics used by investors to predict market value.


So what is CAPE telling us today?


The S&P 500 is currently at a CAPE of over 26.



The S&P 500 has only been at this level or higher a handful of times in the last 100 years. All of them have coincided with major market peaks.


This is not to say that the market will crash tomorrow. However, there are considerable signs that the market is in trouble.


Those of you who have been reading us for some time know that we prefer to use nominal GDP as a measurement of GDP growth in the US.


The reason for this is that all “adjusted” GDP data involves a “deflator” metric that is meant to adjust for inflation. The Feds often use an inflation adjustment that is even lower than their official Consumer Price Index metric (which is already massaged to downplay inflation) in order to make GDP growth look greater.


Consider this simple example. Let’s say that the US GDP grew by 10% last year. Now let’s say that inflation also grew by 10%. In this scenario, real inflation adjusted GDP growth was ZERO. However, announcing ZERO GDP growth is a major problem politically. So what do the Feds do? They claim that inflation was just 8%, and BOOM you’ve got 2% GDP growth announced for a year in which real GDP growth was actually zero.


By using nominal GDP measures, you remove the Feds’ phony deflator metric. With that in mind, consider the year over year change in nominal GDP that has occurred.



As you can see, we’ve broken below four, the reading that has been triggered at every recession in the last 30 years.


The primary drivers of asset prices are the economy and corporate earnings. The above chart shows that the US is on the brink of a recession. With that in mind, consider that corporate profits are at all time highs.


Not only that, but corporate profits, as a percentage of GDP are at all-time highs. Never before in history have corporations made so much money relative to the US economy. This trend is not likely to continue.



So, we have a weak economy, record profits (mostly from cutting payroll by firing people) and record profits as a percentage of GDP. The simplest interpretation of this is that there will be a reversion to the mean at some point.


So… we’ve got:


1)   Stocks overpriced based on the most predictive metric out there (the CAPE).

2)   The US economy at or near recession territory.

3)   Corporate profits at record highs.

4)   Corporate profits as a percentage of GDP at record highs.


The market is primed to drop. Now is the time to prepare.


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Best Regards


Graham Summers


Phoenix Capital Research