Nobody can know for certain--beyond the fact that U.S. financial markets are in historically above-average valuation levels--what could happen next.
Some rationally expect a reversion to mean, which will mean lower valuations.
Others just as rationally argue that above-average valuations can persist for some time, and that a correction is not in store. AI might be among the reasons, if it changes growth expectations.
Consider the Cyclically Adjusted Price-to-Earnings Ratio (CAPE), widely considered a valuable long-term valuation metric. The current CAPE is high, suggesting caution and a likely correction to lower levels.
But many analysts believe that changes in accounting rules since the early 2000s make the standard version look artificially high relative to its historical average. Adjusted, it might still be high, but not at internet bubble levels.
The CAPE is calculated as the current S&P 500 Price divided by the average of 10 years of inflation-adjusted earnings.
The issue is that the denominator uses reported GAAP earnings, and those earnings have become more conservative over time, leading to a boost in CAPE that make comparisons with past levels misleading, the argument goes.
Key accounting changes include:
Goodwill impairment rules (FAS 142, adopted in 2001)
Large acquisition write-downs now hit earnings immediately.
Before 2001, many such costs were spread over decades.
This depresses modern earnings compared with earlier periods.
Mark-to-market accounting
lk;juring crises, companies must recognize large non-cash losses.
These can sharply reduce earnings even if long-term economics are less affected.
One-time charges
Restructuring costs and impairments are recognized more aggressively.
The result is that the denominator in today’s CAPE is lower than it would have been under earlier accounting rules, making the ratio appear higher.
Economist Jeremy Siegel argues for using National Income and Product Accounts instead of GAAP earnings, to better normalize over time.
The standard CAPE can overstate market valuation materially because recent earnings include unusually large accounting write-downs by roughly 10 percent to 25 percent.
Others argue for using operating earnings rather than reported earnings, which also can adjust earnings by 15 percent.
Using such methods, the market still appears expensive, but less so than it might appear.
Other issues:
Lower interest rates over long periods
Higher profit margins
Global diversification of large U.S. firms
Greater use of stock buybacks instead of dividends
Stronger institutional ownership and retirement savings flows.
These factors may justify a structurally higher "normal" CAPE than the 19th- and 20th-century average.
So some will argue a practical adjustment for accounting changes is to reduce the published Shiller P/E by 10 percent to 25 percent.
This suggests the market may still be richly valued, but not as dramatically overvalued as the unadjusted Shiller P/E implies.
It is a useful gauge of long-term valuation, but it is not a short-term market timing tool, as history shows that markets can continue to rise for years, even when the CAPE ratio is well above its historical average.
Several forces can keep markets rising despite expensive valuations:
Earnings continue to grow
Corporate profits may rise fast enough to justify higher prices
Investor optimism and momentum
Strong sentiment can sustain elevated valuations for extended periods
Low interest rates
When bond yields are low, investors are willing to pay more for equities
New technologies can create expectations of stronger future growth
Retirement contributions, buybacks, and institutional inflows can support prices.
The point is that valuation is a poor short-term timing tool:
A CAPE above average tells you expected long-term returns may be lower, but it does not predict when prices will stop rising
Markets can stay expensive for years
If profits rise rapidly, high valuations can become more sustainable
Structural changes matter (lower inflation, global market reach, and dominant technology companies may justify higher valuation ranges than in earlier eras).
We still have to make our own choices about timing, though!
