The Shiller CAPE (Cyclically Adjusted Price Earning) Ratio assesses the valuation of stocks in the context of their inflation-adjusted price-earning ratios as averaged over the long term, i.e. ten years.

(Read more about the ratio here and here)

The S&P 500 is over-extended by this measure

Applying Shiller’s Cape Ratio to the S&P 500 yields a value of 26, very high in the historical context and possibly indicating that the market is overbought and therefore vulnerable to a correction or slower returns in the future.

Cape-Ratio-pic Large Cap CAPE Ratio
CAPE Ratio

“The inflation adjusted PE is at the third highest level in 135 years,” says Richard X Bove, Vice President Equity Research at Rafferty Capital Markets in his research note of August 1 titled ‘Applying the Shiller Methodology to Bank Stocks.’

“At 26 times earnings, it has only been surpassed in 1929 and 2000,” he says.  “This is causing many to fear a major market collapse.”

CAPE Ratio applied to large cap bank stocks

In an interesting study, Bove and colleague applied the Shiller CAPE Ratio to large cap bank stocks, represented in the SNL Large Cap Bank Index, to gauge their present day valuations.

The following 22 bank stocks, all with market caps north of $5 billion, participate in the index:

Index-bank-stocks

In the above chart, 66.42% weightage is accounted by Bank of America Corp (NYSE:BAC), Citigroup Inc (NYSE:C), JPMorgan Chase & Co. (NYSE:JPM) and Wells Fargo & Co (NYSE:WFC).

The study found that the CAPE ratio for these 22 stocks stood at 11.87 as on June 2014. The mean CAPE ratio during the period January 2004 to June 2014 was 11.75 and the median CAPE was 10.41.

Chart-bank-cape

Commenting on the result, Bove said, “Big banks are well below any threshold that would suggest that their values are overextended. In fact, at present, they are selling almost exactly at the average valuation of the past ten years.”

Given that banks are expected to report better earnings for this year, the ratio is expected to fall, making these stocks appear cheaper.

“Using the Shiller technique banks are either fairly valued or undervalued,” says Bove.

CAPE Ratio – Banks Negative perceptions

Banks stocks’ prices may also have been under pressure these past few years due to a constant flow of bad news relating to legal issues from mortgages, fines and penalties imposed by regulators for various transgressions and tightened regulatory compliance resulting from the financial crisis.

In fact, regulatory crackdowns on proprietary trading have resulted in banks discontinuing these operations, causing star personnel from the largest banks leaving for greener pastures in better paid and lightly regulated hedge funds.

A Fitch study of banks’ Q2 earnings revealed that continuing legal costs and fall in FICC activities could pressure large bank earnings in the near term. Fitch also noted that regulatory and compliance related costs are on the rise at these big banks.

Media reports are also speculating on the possibility that US banks could see outflows of up to $1 trillion in deposits once the Fed is finished with its easy money policy and is forced to raise interest rates in acknowledgement of a recovered economy. Banks would have to live with a new reality – huge fund outflows in contrast to the flood of extra cash unleashed by the Fed in response to the global financial crisis.

This risk was also confirmed by Fitch said that deposits with US banks could be vulnerable to a rapid outflow in the event of repricing with the end of QE.