The Shiller CAPE ratio—one of the most respected long-term valuation metrics in finance—currently stands at approximately 39.5. That's not just elevated. It's the second-highest reading in 153 years of market history, exceeded only by the peak of the dot-com bubble in 2000.
For investors riding the AI-fueled rally of 2024-2025, the message from history is uncomfortable: every previous period of extreme valuations has eventually been followed by significant market declines.
What the CAPE Ratio Measures
The cyclically adjusted price-to-earnings ratio, developed by Nobel laureate Robert Shiller, divides the S&P 500's price by its average inflation-adjusted earnings over the previous ten years. This smoothing eliminates the distortions of single-year earnings spikes or collapses.
Key reference points:
- Historical median: 16.0
- 20-year average: 27.3
- Current reading: 39.5
- All-time high: 44.2 (December 1999)
At current levels, the CAPE is 44.7% above its recent 20-year average and roughly 147% above the historical median.
What History Shows
The relationship between CAPE and subsequent returns is well-documented:
High CAPE periods: When CAPE exceeds 25, subsequent 10-year real returns have typically averaged 3-5% annually—far below long-term market averages.
Low CAPE periods: When CAPE falls below 15, subsequent 10-year real returns have historically averaged 10-12% annually.
Extreme CAPE periods: The current reading implies future annual returns of roughly 1.5%—essentially flat in real terms over the next decade if history holds.
Previous CAPE Peaks
Looking at what followed historical CAPE extremes:
1929 (CAPE ~30): The market crashed and didn't recover its real value for 25 years.
2000 (CAPE ~44): The S&P 500 fell approximately 50% over the following two years and didn't sustainably exceed its 2000 peak until 2013.
2021-2022 (CAPE ~38): The market declined roughly 25% from peak to trough before recovering.
The pattern is consistent: extreme valuations don't guarantee immediate crashes, but they've reliably preceded periods of disappointing returns.
Why This Time Might Be Different (Or Not)
Bulls offer several arguments for why current valuations are justified:
AI transformation: Artificial intelligence may be driving a genuine productivity revolution that justifies higher multiples.
Low real rates: Even with Fed tightening, real interest rates remain relatively low by historical standards, supporting equity valuations.
Earnings quality: Today's S&P 500 companies have higher profit margins and stronger balance sheets than historical averages.
Accounting changes: Some argue that 1990s accounting rule changes make historical CAPE comparisons less relevant.
Bears counter:
AI monetization uncertain: The AI spending boom may not translate to proportional profits—the same dynamic that caused the dot-com bust.
Rate normalization: The Fed has signaled rates will remain elevated, increasing the discount rate applied to future earnings.
Concentration risk: A handful of mega-cap tech stocks drive S&P 500 valuations; the median stock is less expensive.
What the CAPE Doesn't Tell You
The CAPE ratio has significant limitations as a timing tool:
No timing signal: Markets can remain overvalued for years. The CAPE exceeded 25 in 1996 but the market didn't peak until 2000.
Regime changes: Structural economic shifts can make historical comparisons misleading.
Alternative metrics: Other valuation measures paint varying pictures. The forward P/E ratio, while elevated, looks less extreme than CAPE.
How to Think About Valuations
For long-term investors, elevated CAPE readings suggest several approaches:
- Temper return expectations: Planning for 5-6% annual returns rather than historical 10% averages is prudent
- Consider diversification: International markets, particularly emerging markets, trade at significantly lower valuations
- Focus on quality: Companies with strong balance sheets and consistent earnings may prove more resilient
- Maintain discipline: Avoid the temptation to chase momentum in the most expensive market segments
- Stay invested: Timing the market based on valuations alone has historically been unprofitable
The Bottom Line
The CAPE ratio is flashing a clear warning: U.S. stocks are expensive by almost any historical standard. That doesn't mean a crash is imminent—markets can stay irrational longer than investors can stay solvent, as the saying goes.
But for investors making decade-long plans, assuming the returns of the past two years will continue indefinitely is historically naive. The second-highest CAPE reading in 153 years deserves respect, even if it doesn't demand immediate action.
