- In the long run, corporate performance is defined by economic activity.
- The CAPE ratio is an excellent metric, but it has some limitations which we discuss.
- According to this metric, stocks have been more expensive only once: during the peak week of the dot-com bubble.
In the long run, there is no other way for stocks to go than to follow economic fundamentals.
Economic activity is what defines corporate growth and earnings. In the short term, this can be skewed by euphoria that pushes stocks into overvalued territory or by pessimism that creates unbelievable bargains (just remember 2009).
So how can you know when stocks are overvalued or undervalued? The most commonly used metric is the price to earnings ratio (P/E) ratio. However, the P/E ratio is very volatile and heavily under the influence of economic activity. More →