Deutsche Bank is wary of a ‘significant correction’ for US equities

Deutsche Bank analysts are careful of a ‘significant correction’ for US equities.

Turning points can happen quickly

When valuations are stretched to start with, there can be limited scope for further gains

Examples of high returns through history have often been followed by sizeable reversals

DB note that the CAPE ratio for the S&P 500 has only been higher on two other occasions in the last century:

• during the dot-com bubble of the late 1990s
• the period before the Global Financial Crisis in 2008
• “there was little scope for further gains since valuations were already so stretched to start with, and they were each followed by a significant correction”
• on both occasions the CAPE ratio has got as high as it is today, there was then a significant correction

DB will probably be correct at some stage. But when?

And, some proven performers are also very wary:

• Buffett’s Berkshire Hathaway hoarding cash in a pattern seen before the financial crisis

***

If you need, here is a quickie CAPE explanation.

The Cyclically Adjusted Price-to-Earnings (CAPE) Ratio is sometimes referred to as the Shiller P/E ratio, after its developer, economist Robert Shiller:

• its a valuation metric for equity markets
• it provides a long-term perspective on market valuation by adjusting for economic cycles

Key Features:

1. Adjusted Earnings:The CAPE ratio divides the current price of an index (e.g., the S&P 500) by the average real (inflation-adjusted) earnings of the index over the past 10 years.

2. Purpose:

   • Smoothes out short-term fluctuations in earnings caused by economic cycles, such as booms and recessions.
   • Helps investors assess whether a market is overvalued, undervalued, or fairly valued based on historical trends.

3. Interpretation:

   • High CAPE Ratio: Suggests that the market is overvalued and may offer lower future returns.
   • Low CAPE Ratio: Indicates undervaluation, potentially signaling higher future returns.

4. Use Case:

   • Primarily used for long-term investment decisions rather than short-term market timing.
   • Often referenced to assess market conditions and compare current valuations to historical averages.

While the CAPE ratio is widely respected, critics note that it may not fully account for structural changes in markets or unusual events (e.g., tax changes or sectoral shifts).

This article was written by Eamonn Sheridan at www.forexlive.com.