The Market's Big Warning Is Missing the Point

Editor's note: Every Friday, we showcase a featured topic from our YouTube show, Altimetry Authority.

This week, we tackle themes from today's episode, which airs at 8 a.m. Eastern time.

Read on below to learn about a recent economic "red flag"... and why it might not be as bad as it seems...

The financial media is hitting its favorite panic buttons...

It's no secret valuations are high. The market's Uniform price-to-earnings (P/E) ratio is around 24 times... above the 20 times long-term average.

The Buffett Indicator, which compares the total market cap of U.S. stocks with GDP, just hit an all-time high of 225%. That's way higher than the 70% to 80% range Warren Buffett says is ideal for making an investment.

And then there's the Shiller cyclically adjusted price-to-earnings ("CAPE") ratio. It just crossed 40... a level last seen during the dot-com bubble.

That has triggered another wave of bearish calls. Some economists are predicting a 40% crash for the S&P 500. Folks are even suggesting we're in one of the most overvalued markets of all time.

On the surface, this environment does look extreme. The Shiller CAPE ratio has only crossed 30 a handful of times since 1871. Each time preceded a major drawdown.

This ratio can be an important warning sign. But it also comes with some big problems. And as is so often the case, it all goes back to as-reported accounting...

The Shiller CAPE ratio is supposed to be a better version of standard P/E...

It smooths out cyclical earnings by taking the average of the past 10 years, adjusted for inflation. That makes it less sensitive to booms and busts.

So it should offer a clearer long-term view of market valuation. And to be fair, it has done a decent job of calling peaks. The CAPE ratio flashed warnings ahead of both the Great Depression and the dot-com bubble.

But there's one problem. And it's a big one...

CAPE still relies on as-reported earnings.

That means it inherits all the flaws of generally accepted accounting principles ("GAAP")... especially GAAP's tendency to punish companies with large, non-cash expenses.

Adjusted earnings tell a very different story...

Economist Jeremy Siegel has long warned about this distortion. In a 2016 paper, he showed that CAPE's overvaluation signal shrinks significantly when you use sources that aim to measure cash earnings.

Back then, the CAPE ratio was 54.6% above its historical average. But when recalculated using S&P's operating earnings, that number fell to 40%. And when using the U.S. Bureau of Economic Analysis' national income and product accounts ("NIPA"), it fell to just 19% overvalued.

(NIPA attempts to measure cash-based operating earnings as accurately as possible, ignoring all non-cash expenses.)

And it's not just a one-off. Time and again, the Shiller CAPE ratio has come in far above versions that look at cash earnings...

That massive difference is a clear sign investors shouldn't take the headline number at face value.

In fact, Siegel's findings show that once you correct for these accounting changes, today's market is still expensive... but not wildly so.

Depending on which adjusted measure you use, valuations are overstated by somewhere between 10% and 40%.

And the bigger the difference between GAAP earnings and cash earnings... the bigger the rift between each ratio and reality.

Look, we're not denying that valuations are high...

As we said, Uniform P/E is sitting at about 24 times. That's above the long-term average of 20 times.

But before you join the panic over today's 40 times Shiller CAPE ratio, it's worth remembering this number is distorted by GAAP quirks. It doesn't reflect what's actually happening with today's businesses.

Interest rates are finally falling. And that's helping spur more dealmaking and record corporate profits. We're still seeing plenty of bullish signals.

Markets aren't dirt cheap. But they're not pricing in perfection, either. There's a big difference between expensive and unsustainable.

Regards,

Joel Litman
November 7, 2025

P.S. We'll dive deeper into the Shiller CAPE ratio in today's episode of Altimetry Authority. New episodes air every Tuesday and Friday at 8 a.m. Eastern time.

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