What does the chart show?
This chart shows the median five-year annualised return of stocks at a given Cyclically Adjusted Price-to-Earnings ratio (CAPE) for an equally weighted universe of all UK stocks with a market cap over £100m, over the past 30 years. The CAPE ratio is a valuation tool that measures a company’s share price relative to its earnings per share over an extended period of time. There is a clear relationship between CAPE ratios and subsequent five-year returns, with a lower CAPE ratio being a good indicator of an undervalued market with opportunities for returns. At the beginning of the year, the CAPE ratio for this universe of stocks stood at 22.6x, one of the highest on record. UK markets have suffered this year with the FTSE All-Share down over 7% in GBP terms. This fall in share prices has brought the median CAPE ratio down to just 14.3x, which is not far from being the lowest we have seen in a long time.

Why is this important?

In recent years loose monetary policy, excess liquidity and near-zero interest rates have pushed stock valuations considerably higher. In many cases share prices have risen far beyond levels that could reasonably reflect the fair values of companies. This has meant that investing using a value-based approach has been harder as well-valued companies with good opportunities for future growth have become rarer and rarer. However, the economic headwinds and uncertainty in markets have led to almost indiscriminate selling across UK markets as some investors have grown fearful. Prices have fallen and although earnings have also been affected, their declines are far less relative to falls in share prices. Some valuations across the market still remain elevated, but the median CAPE ratio for this particular universe of stocks has now fallen to levels that historically have provided excellent opportunities to investors that know where to find value. Despite the economic turmoil and uncertainty facing markets, there remains reason to be positive for those willing to take a longer-term approach to investing.

Additional Note: A data error resulted in the publishing of an inaccurate chart for the 06/10/2022 Chart of the Week Podcast. The error has since been amended and the updated chart can be found here. We apologise for any inconvenience caused.