When is the best time to invest in the stock market? A common tool used to determine if the market is cheap or expensive is the price to earnings, or PE ratio. The PE ratio tells us how much we pay for a rupee of earnings. A higher PE ratio means that the stock market is relatively expensive.
The problem with the PE ratio is that earnings are volatile. During a downturn, earnings drop, and the PE ratio goes up. But this does not indicate that the stock market is expensive. The stock market prices in the fact that earnings will recover when the downturn ends.
A better way to value the markets
The solution to this problem is the cyclically adjusted price to earnings ratio, or CAPE. The CAPE ratio uses smoothed earnings over a longer period, typically ten years. Thus, it removes volatility that comes from business cycle fluctuations. It is a much better signal of the market’s long-term value. Here is a plot of the CAPE ratios for the BSE Sensex and NSE Nifty indices.
The current values (as of May 2025) are 35.2 for the Sensex and 41.1 for the Nifty. The long-term averages are 24.7 for the Sensex and 28.0 for the Nifty. This means that current valuations are high, relative to their historical averages. To get a better sense of this, current values are in the top ten percentile compared to their history. This means that at least 90% of the time, the cape ratios have been lower than they are today.
A good predictor of returns
The maximum values in these series are around 50, which occurred in December 2007. And for those of you old enough to remember, the stock market crashed in 2008.
The CAPE ratio turns out to be a good predictor of future stock returns. This is true primarily at longer horizons (e.g. 5 years). When the CAPE ratio is high, future returns are low, and vice versa. To be clear, a high CAPE ratio is not an indicator to sell stocks. Future returns are positive even when the CAPE ratio is high. They are just below average. For an investor, this means that allocation to the stock market should be reduced (but still positive) when the CAPE ratio is high.
The CAPE ratio is published for many countries. Thus, it can also be used to compare valuations across countries for those investing in international markets. For example, the current CAPE ratio for the US stock market (S&P 500) is around 38. This means the US stock market is approximately as expensive as the Indian stock market.
One limitation of the CAPE ratio is that it does a poor job of predicting returns at short horizons (e.g. 1 year). Thus, it is not a useful tool to time the stock market in the short or medium term. But for long term investors, it has tremendous value. It should be a part of every investor’s toolbox.
Note: The purpose of this article is to share interesting charts, data points and thought-provoking opinions. It is NOT a recommendation. If you wish to consider an investment, you are strongly encouraged to consult your advisor. This article is for strictly educative purposes only.
Asad Dossani is an assistant professor of finance at Colorado State University. His research covers derivatives, forecasting, monetary policy, currencies, and commodities. He has a PhD in Economics. He has previously worked as a research analyst at Equitymaster, and as a financial analyst at Deutsche Bank.
Disclosure: The writer does not hold any of the assets discussed in this article
Disclaimer: The purpose of this article is only to share interesting charts, data points, and thought-provoking opinions. It is not a recommendation. If you wish to consider an investment, you are strongly advised to consult your advisor. This article is strictly for educational purposes only.