CAPE, Future Expected Equity Returns, the Equity Premium, and Market Timing

I think this, by the very sharp Justin Lahart is badly framed.

Shiller’s CAPE a hair over 27 is telling us that if we buy the S&P Composite and hold it to infinity, we can expect a real return to average 5%/year ±, where the ± can, of course, be substantial. But there is also a reasonable chance that in the next five years the CAPE valuation ratio will revert to 20–in which case you lose 25% on top of that if you have to sell then. And there is some chance that in the next ten years the CAPE will kiss the 15 it kissed in 2009–which means that if you have to sell then you could lose 45%.

The stock market is for prudent, patient investors–not for those who know they will have to sell soon and cannot stand the risk of price declines, or who do not have to sell soon but cannot stand the risk of scanning the newspaper and seeing a disappointing number.

But what other investment promises an expected return of 4%/year for the patient investor? And it is difficult to imagine that any other asset class is exposed to much risk: what will preserve its real value if the collective ownership of the productive capital of the world does not?

With interest rates at their current level of -2%/year real, a CAPE of 27 is not flashing “sell” unless you think the odds of CAPE reverting to 20 in the next year are a quarter or greater.

And, of course, Justin’s point is that the CAPE* that we should be watching is not 27, but rather 18, in which case the real return we should expect on average is not 5%±, but 7%±:

Justin Lahart: Shiller’s Powerful Market Indicator Is Sending a False Signal About Stocks This Time:

A popular valuation metric pioneered by Nobel Prize-winning economist Robert Shiller says that stocks are dangerously expensive. But it may be sending a false signal…

Shiller gained popular fame with his 2000… “Irrational Exuberance”… [and] in a 2005 edition of the book, Mr. Shiller said the housing market was in a bubble. It is a track record that makes Mr. Shiller hard to ignore…. The CAPE  is now at 27… well above its 50-year average of 20. The only times the CAPE has been higher were during the 2000 bubble and bust, and just prior to the 1929 crash….

An alternative CAPE, constructed by The Wall Street Journal… relies on a more consistent earnings measure: The Commerce Department’s quarterly data on total U.S. after-tax corporate profits… Federal Reserve data on the total value of the U.S. stocks, rather than the value of the S&P 500. The result: Stocks look much cheaper than Mr. Shiller’s data suggests….

The two measures tracked each other almost perfectly for decades until 2008, when banks and other businesses, required to follow the latest GAAP rules, suffered huge write-downs that cut earnings. The Commerce Department’s measure, which hasn’t changed, treats bad-debt expenses, asset write downs, and loan-loss provisions as capital losses… rather than cutting earnings. Since both of these measures rely on 10 years of earnings, the disparity stemming from the financial crisis has persisted….

A bigger issue, says Mr. Campbell, is that just because the CAPE is high doesn’t mean that stocks aren’t a better value than comparable, safe investments. Back in 2000, there were great alternatives to expensive stocks, such as 10-year Treasury inflation-protected securities offering a government-guaranteed yield of 4 percentage points above inflation. Today those bonds offer no premium. While stocks are currently expensive, Mr. Campbell says, it isn’t clear that they are a worse investment than their alternatives….

Aswath Damodaran… over the past 50-odd years, he couldn’t find a single way he could make CAPE beat a simple buy-and-hold strategy…. Shiller agrees that the CAPE can’t be used as a market-timing tool, per se…

And I wince at the graphic design of this chart:

Shiller s Powerful Market Indicator Is Sending a False Signal About Stocks This Time WSJ


Brad DeLong


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