One way to decipher if the stock market is over- or undervalued

Julie Brownlee, Fsp Invest, 30 Jun. 2014

Tags: cape, stock market, market, calculate cape, cape ratio, investing strategy, what is cape, pe ratio, overvalued market, undervalued market

The logic behind making money on the stock market is simple. You ‘only’ have to buy low and sell high. In other words, buy when the markets are cheap and sell when they’re expensive. If only it was as easy as that. Even when some assets look cheap, they can drop further in value. And some even lose all their value. The opposite works with expensive assets, which inevitably ends in a bubble bursting. So how can you measure if the market is cheap or expensive? Read on to find out…

The wonders of the CAPE ratio

The cyclically adjusted price earnings (CAPE) ratio can show you if a market is very over or undervalued.

It’s like a more complicated price earnings (PE) ratio, John Stepek in Money Week explains.

To get the standard PE ratio, you divide the overall market capitalisation (cap) by earnings for one year. A low PE suggests the market is cheap. A high PE suggests the market is cheap.

The PE ratio does have its drawbacks though. It doesn’t look at any differences going on in the business cycle. So when times are good and earnings are good, the market might look cheap compared with what it’s trading at.

But if the economy is on the brink of a recession, then you wouldn’t want to invest then. And that’s where CAPE comes in. It makes allowances for changes in the business cycle caused by the economy enduring ups and downs.

How to calculate CAPE

CAPE takes the annual earnings for the past ten years and averages them out. Then you divide the current market cap of the market by this average earnings number.

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The ratio smoothes out any changes in earnings that are down to the fluctuations in the economic cycle. And from this you can gauge whether the market is cheap or expensive at the time.

So there you have it, one way to decipher if the market is over or under valued.

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