You might be surprised to know I spend very little time each year studying the economy. Not because the economy is dull, but because it has little to do with earning a good return. Lots of data show almost no relationship between economic performance and the stock market. But from a more common sense approach, being able to correctly and repeatedly figure out how the hundreds of economic variables come together is impossible. We are mere humans and our brains just aren’t designed to deal with such a massive multi-factor model.
To that end, I’ve read some articles recently about how one economic indicator, the Cyclically Adjusted Price Earnings Ratio (or CAPE), shows the market to be over-valued. Although the chart below looks ominous, this dog’s bark is worse than its bite.
The idea behind CAPE is usually credited to Yale Professor Robert Shiller. He calculated it by dividing the total market value of all companies in the S&P 500 by their average earnings over the last 10 years. If the ratio is above the long term average of 16, the market is said to be expensive. If it’s below average, the market is said to be cheap. The market’s current reading of 25.32 is causing some people to worry.
Even Shiller in a 2013 interview cautions against using CAPE to time short-term market moves. Instead, he argues it’s more useful to think about CAPE as showing a range of possible long-term outcomes over the next 10-20 years. At the current level, CAPE indicates that average investors should expect a return of about 3% per year (adjusted for inflation) over the next decade.
Using historical data, Credit Suisse put together a good illustration of actual short-term returns at various CAPE levels. As you can see below, even most of the high CAPE levels still produce positive results over three year investment periods. At our current mark of 25, Credit Suisse shows average returns of more than 5% per year (adjusted for inflation) over the next three years. All of the sudden the chart above doesn’t feel as scary.
One of the primary reasons CAPE isn’t a good market timing indicator is interest rates. Comparing today’s CAPE to a past number is misleading because it overlooks the effects of today’s lower rates. In a low interest rate environment like today, any earnings above the long term government bond rate are going to be more valuable, and therefore increase what an investor is willing to pay for stocks. Therefore low rates naturally lift CAPE over time. We can see this in Japan, where decades of low interest rates have boosted their average CAPE to 41.
Also, earnings today are calculated differently than they were even 40 years ago due to changes in accounting rules. Another overlooked factor is dividends. Companies today pay out far less of their earnings in the form of dividends than they did in the past. Adding the value of those dividends back into the CAPE calculation makes stocks look far more attractive.
In all, using CAPE (or other broad valuation metrics) to make predictions about the stock market is not a good idea. Until we see CAPE off the charts in one direction or another, we should assume that stocks are trading “in a range of reasonableness”. If you still need more assurances, watch Warren Buffett agree in the youtube below. Not all heroes wear CAPEs.
That concludes this year’s 15 minute study of the economy. That was about 12 minutes too long to figure out what we already know – stick to high quality companies.
Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.