Is the Indian stock market overheated? What the CAPE ratio tells us
Cyclically Adjusted Price-to-Earnings (CAPE) ratio, also known as Shiller’s P/E.
The role of CAPE ratio in predicting crashes
<div data-placement=«Mid Article Thumbnails» data-target_type=«mix» data-mode=«thumbnails-mid» style=«min-height:400px; margin-bottom:12px;» class=«wdt-taboola» id=«taboola-mid-article-thumbnails-115173583»>In 2000, right before the tech bubble burst, the CAPE ratio for the U.S. stock market reached record highs. Again, in 2007, just before the global financial crisis, the ratio peaked. The CAPE ratio has historically been an indicator that signals when stocks may be overvalued and potentially due for correction. With India’s CAPE ratio now around 43, alarm bells are ringing, as it hovers near levels seen before the 2008 crisis. Adding to the unease, foreign institutional investors (FIIs) have withdrawn nearly $7 billion from Indian equities in October alone.
So, should investors be worried about a crash in the Indian stock market? While the answer isn’t straightforward, the CAPE ratio is worth understanding to get a fuller picture of market dynamics.
Understanding P/E and CAPE ratios
To appreciate the CAPE ratio, one must first understand the traditional price-to-earnings (P/E) ratio. The P/E ratio measures a stock’s current price relative to its earnings. For instance, if a company has a P/E of 25, it means investors are willing to pay 25 times the company’s earnings for a share. A higher P/E can signal that investors expect significant future growth, although it may also mean that the stock is overpriced relative to its current value.
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