By one very important measure, stocks are set to crash. This will not be any old crash, but a really major one – as significant as 1929, 1987 or what we saw in 2000 and 2008. And the measure that tells us this is not some obscure ratio, familiar only to academics locked away in ivory towers; it is the ratio that many of the world’s top investors say is the single most important ratio they use to judge whether or not stocks are overvalued. Yet despite this very powerful evidence to say we are set to see a crash, many say that this time it is different. Are they right this time?

The measure that looks so dangerously elevated is called the CAPE – or the cyclically adjusted price earnings ratio. It is calculated by taking the current capitalisation of stocks, and comparing it with average earnings over the last ten years.

For US stocks right now the CAPE is 23.8. The long term average is 16.5. Ergo US stocks are overvalued. And although stocks listed in London are not as expensive, the markets across the world tend to follow the US. If US stocks crash, others will follow, regardless of fundamentals.

Bullish defenders of US stocks are saying: “This time it is different.” And they are greeted with derision. There is one golden rule in investing. When people say: “this time it is different,” sell.

It is just that when you think about it, of course, US earnings over the last ten years have been low; the US economy has suffered a very nasty recession. The CAPE, they say, is distorted by the unique, and never to be repeated experience of 2008.

Besides, add the bulls, the CAPE is not the only measure. Look at current PE ratios, look at stock values to net assets, look at a myriad of other measures, and stocks don’t look that expensive at all. They can even turn the “this time it is different” argument back on their critics, and say: “but by a long list of measures stocks are not expensive, why do you think they will crash?” To the bears they might say: ”Are you saying this time it is different?”

But then we get a counter argument. Sure, the US has suffered one mother of a recession, but corporate profits did surprisingly well. The truth is that corporate profits to GDP are close to an all-time high. The argument continues, if the ratio returns to its historic average, earnings will fall, even if GDP rises.

And finally just to retort to that argument about profits to GDP being high and thus they will fall, some might say: “Yes it is true that profits to GDP are exceptionally high, but this has been a bad thing, and it may have been a factor that triggered the crisis of 2008.” To explain this argument, see it this way: the economy needs demand to rise for growth to occur. If profits to GDP are rising and wages to GDP are falling, demand can only occur if people borrow more. Hence high levels of debt were a symptom of rising profits squeezing wages. If we see the ratio return to average, that will be good for the economy, and in the long run, what is good for the economy is good for company profits.

So where does that leave us? If profits to GDP fall, that may be negative for stocks in the short term, but positive in the long term. If profits to GDP stay where they are, that may lead to earnings rising with the economic recovery, justifying stock valuations, but this may not be so good in the long run.

© Investment & Business News 2013