FEW measures of stockmarket valuation are as controversial as the cyclically adjusted price-earnings ratio, or CAPE. American equities have looked expensive on this measure for most of the past 20 years, which is why many bulls tend to dismiss its usefulness. It is pretty clear that the CAPE does not help investors to time the market.
But a new paper* from Research Affiliates, a fund-management group, explains why many criticisms are overblown. The strongest case for the measure is that a higher ratio tends to be associated with lower long-term returns. A study of 12 national markets shows that a 5% increase in the CAPE, from 20 to 21, say, tends on average to reduce the total ten-year expected return by four percentage points.
The attraction of the CAPE is that it smooths out the vicissitudes of the profit cycle. In a recession, profits can plunge even faster than share prices. So if you look only at the ratio of a share price and the previous year’s profits, the market can look very expensive. Since it is a moving average of profits over ten years, the CAPE is less volatile. Past peaks have coincided with the top of bull markets, as in 1929 and 2000 (see chart). It is now well above its long-term average.
Critics say that the high value of the CAPE can be easily explained. One argument is that profits have shifted to a permanently higher level. Accounting standards have changed and modern companies, such as Google and Facebook, have more market power. Another line of argument is that, regardless of the level of profits, valuations should be higher. Demographic changes mean that baby-boomers are piling into equities as they prepare to retire. Low real interest rates mean future profits, when discounted, are worth more today. General economic and financial risks have fallen.
The paper tries to tackle those arguments. The authors accept that the current level of profits is high. But they do not believe that this means future profits growth will necessarily be strong. There is a tendency to revert to the mean. Historically, rapid growth in profits over a ten-year period is associated with slower growth over the next decade. Furthermore, the high level of profits is linked to slow growth in wages. That has led to a populist backlash, which could result in higher taxes on companies or restrictions on trade.
The demographic argument also has its flaws. The baby-boomers are already in the process of retiring, which means they will be running down their savings pots rather than building them up. Furthermore, the ageing population means that the workforce will grow more slowly in future. Other things being equal, that will be bad for both economic growth and profits.
As for the impact of low interest rates, a lot depends on why rates are low. If they are depressed because central banks expect slow economic growth, that is not great for equities. Arguments based on low macroeconomic volatility tend to be hostages to fortune; there was much talk of the “great moderation” in the early 2000s, just before the financial crisis hit.
Finally, other countries also have low interest rates, reduced volatility and ageing populations, without their markets trading on anything like the CAPE that Wall Street does. America’s ratio is 32.8, whereas Canada is trading on a CAPE of 20. Germany is on 19 and Britain on 14. All are trading near their historical averages; in contrast, Wall Street is at double its usual level. America may have more powerful companies, but that is a very large gap to attribute to a single factor. Alternative measures of stockmarket valuation, which compare share prices with corporate sales or asset values, also show that Wall Street looks expensive, relative to history, but that other countries (particularly emerging markets) look cheap.
Plenty of sceptics will fail to be convinced by this reasoning. They will point out that the American CAPE has been consistently over 20 since 2011, well above its historic average of 16.8. Yet the markets have continued to perform well, admittedly helped by a huge amount of stimulus from the central banks.
But they should consider what their optimism implies for the future. American pension funds are expecting returns of 7-8% from their portfolios. That would require some combination of decent economic growth, continued low interest rates, a bigger share of profits in GDP and even higher valuations. If you believe in all that, this columnist has some crypto-currencies he would like to sell you.