Are Stocks Overvalued? Maybe Not!

  • U.S. stock market valuation is the third highest in its history
  • Shiller’s CAPE is one of the best indicators to measure valuation
  • Current numbers show expected future U.S. stock market returns of 2–5% annually, below the average of 10% per year
  • Investors need to adjust their expectation if they do not want to be caught by surprise

There has been a lot of talk about high valuations in the U.S. stock market. Measured by Shiller’s CAPE, one of the best indicators for the level of valuations, stocks are approaching one of the highest levels in history. Is it time to sell? Having a single indicator would be nice. But it’s not that simple. Below, we investigate why CAPE might be a useful tool for investors, how to apply it and what to expect for the next ten years.

Shiller-CAPE — Source: Robert Shiller, Price earnings ratio is based on average inflation-adjusted earnings from the previous ten years, known as the Cyclically Adjusted PE Ratio (CAPE Ratio), Shiller PE Ratio, or PE 10

Shiller-CAPE — Source: Robert Shiller, Price earnings ratio is based on average inflation-adjusted earnings from the previous ten years, known as the Cyclically Adjusted PE Ratio (CAPE Ratio), Shiller PE Ratio, or PE 10

Valuation As An Indicator?

The general belief is that valuation analysis can indicate if stocks are valued highly and have less future potential to go up or if they are valued low and have potential to rise. There is a broad range of indicators to solve this question. Probably the strongest indicators to measure valuation is the CAPE Ration (Cyclically Adjusted Price-Earnings ratio). It was developed by the Nobel Prize-winning economist Robert Shiller of Yale University and his former colleague Prof. John Campbell in 1998. In contrast to most other indicators, CAPE is the real (i.e. inflation adjusted) index price level divided by a 10-year average of real earnings. By using a 10-year average, the CAPE reduces the cyclical element of earnings. According to Shiller, the “CAPE was never intended to indicate exactly when to buy and to sell.” That is exactly what the numbers show. Market valuation explains only 3% of the cumulative price returns over the next year (measured by R2). However, it explains 15% over the next 10 years! Looking at the chart, CAPE correctly warned in the years before 1929, 2000, and 2007 that the U.S. stock market was relatively expensive.

Current Level Are (Too) High?

So valuation, represented by CAPE, seems to be a good long-term indicator and has a track record in pointing out the major turning points in the market. Analysts see CAPE values below 10 as an indication for an undervalued market (followed by higher stock market returns). Conversely, a CAPE Ratio above 25 indicates an overvalued market, with lower expected returns and increase risks of significant stock market sell-offs.

S&P 500 and CAPE values since 1900 — Source: Estran and Jéséquel, Equity Markets Valuation Using CAPE

S&P 500 and CAPE values since 1900 — Source: Estran and Jéséquel, Equity Markets Valuation Using CAPE

Of course, CAPE is not perfect. Many have criticized that the CAPE ratio does not integrate the level of bond yields. Also, accounting standards have not remained consistent over time. Siegel argues that companies report profits more conservatively than they used to, which depresses earnings numbers and hence elevates valuation levels unnaturally. Another challenge, as Siegel observed, is that calling the market over- or undervalued depends on the selected period for the long-term average. Is it right to use an average since 1900? In their recent paper, Equity Markets Valuation Using CAPE, Estra and Jéséquel argue that

“using a long-run average including the Great Depression, both 1st and 2nd world wars and the subsequent Cold War is inappropriate because market conditions are different now. Thus, we propose August 1987 as a starting date for historical comparison since it corresponds to the nomination of Alan Greenspan as the president of the FED”.

Depending on the which time-frame investors use, they might consider the U.S. equity market either as largely overvalued, or just a bit higher than its historical standards.

What Returns Can We Expect?

One way to apply CAPE is to use it to estimate future equity returns. A popular way for this is to combine CAPE with Bogle’s formula, published over 25 years ago by John Bogle (and recently updated), founder of Vanguard. It is a relatively simple formula, which has been working well since Bogle introduced it. According to Bogle, future stock returns are the sum of the dividend yield, earnings growth, and change in P/E ratio (CAPE).

10 year annualized stock returns = dividend yield + earnings growth + change in P/E ratio

 

Bogle’s formula 1900 to 2015

Bogle’s formula 1900 to 2015

Dividend yield and earnings growth are the investment aspects of the investment return, changes in P/E ratio is the speculative return — that is what investors are willing to pay for a dollar’s worth of earnings. Historically, the dividend yield was 4.5% to 5%, and earnings growth was about 5%. With a slight increase in P/E ratio, investors could expect annual returns around 10%.

Outlook: Future Return Below Expectations

Bogle’s formula with CAPE scenarios

Bogle’s formula with CAPE scenarios

However, with a current dividend yield of 2%, there is a loss right there, suggesting lower returns in the future. Earnings growth has been about 5%, lower than in the past. So the expected investment return is already down to around 7%, not taking into account valuations. This is where the CAPE comes in. The table compares various scenarios for changes in CAPE. To maintain >10% annual returns, CAPE had to increase to 40–45, levels only seen during the dotcom bubble. With CAPE returning to averages 17–25 (see discussion above), there would be 2 to 5% annual loss, bringing down expected returns to 2–5% annually.

Summary

Combining CAPE with Bogle’s formula helps investors to adjust their expectations. The market is in the later stage of the current bull market. Valuations, measured by CAPE, are relatively high and there is the danger of changing monetary policy (as we highlighted in our latest article). In this environment, investors need to familiarize themselves with a world where U.S. stock returns might be around 3–5% rather than the historic average of 10% per year.

About Returnboost.com

Returnboost.com provides investors with better risk-adjusted portfolios based on a combination of fully automated and active portfolio management, quantitative Momentum investing and True Diversification. By building an automated investment service from the ground up to put the client first, Returnboost is paving the way for a new generation of investors to achieve their financial goals. Every investor should have access to active investment strategies and risk management solutions. We believe this is a once-in-a-generation opportunity to change an industry and build something new, different and better.

Author: ReturnBoost

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