Those people who are overtly worried about markets trading at historically high valuations, particularly the US market, seem to be in a small and ever-shrinking minority. Why? A key issue is basic investor psychology. Pithily put by pseudonymous blogger Jesse Livermore - not themselves unsympathetic to valuations arguments - “The problem, of course, is that the people who are voicing concerns about valuation today are essentially the same people who were voicing them several years ago, when equity prices were half their current values. And they’re using the same “mean-reversion” arguments to do it, even though the market has persistently shown that it has no inclination to revert back to the valuation averages of any prior era.”
But value investors are not strangers to spending a long time being “wrong” during bull markets only to be proved spectacularly “right” when the market turns. Investment firm Research Affiliates has decided to pour cold water on several the arguments advanced by “CAPE naysayers”. CAPE attempts to look at valuations over an investment cycle by comparing price with average, inflation-adjusted 10 year earnings. The ratio has been shown – most famously by Nobel laureate Robert Shiller – to have a strong relationship with long-term market returns. Put simply, higher CAPEs mean lower returns, lower CAPEs higher returns.
Research Affiliates has run the numbers for multiple markets to demonstrate that “CAPE shows remarkable efficacy in forecasting long-term equity returns, not just in the United States but across the world.” With the S&P 500’s CAPE at 32 – or about 29 if adjustments are made to factor out the big credit-crunch hit to EPS – the prognosis is not good.
True, says Research Affiliates, “CAPE is only one measure of valuation” and that “capital flows drive short-term market behaviour far more powerfully than valuation.” What’s more, one of the article’s authors, the firm’s boss Rob Arnott, has for a long time preferred to view the market’s “equilibrium” level for CAPE as “an upward sloping best-fit line” starting at 12x in 1881 for the S&P 500 and rising to 19x in October 2017. What’s more, there is reason to think periods of low interest rates, economic stability and minimal market volatility can raise the fair-value level of CAPE (perhaps to as much as 23x for the S&P 500 today) “unless those low real interest rates are also predicting abnormally slow earnings growth”.
However, several criticisms of CAPE cause rancour with the authors. Expectations of higher future US EPS growth rates as a reason for a higher CAPE are given short shrift, and not only because “EPS growth is notoriously hard to predict and extrapolating recent history is…a terrible way to forecast”. Indeed, GDP and EPS growth face headwinds from: an aging population; reduced business formation; and the chances of a backlash against the diminishing proportions of GDP distributed to workers as wages (a drop from 50 per cent to 42 per cent since the 1960’s). In all, Research Affiliates thinks “the recent trend of rising US corporate profits has likely run its course”.
Meanwhile, the article finds arguments about the impact accounting rule changes have had on reported earnings don’t add up, pointing out, “even if we embrace the use of operating earnings… it makes comparatively little difference to the outcome when we make the same adjustment to the historic CAPE averages”.
So where does that leave us. Well the good news for UK investors is that with a CAPE of about 14, ours is one of the most attractively valued developed markets with a predicted 10-year return of 6.1 per cent per annum in dollar terms, assuming CAPE and currencies move back to just half their “valuation norms”. Not so good for the US though, which on the same basis is forecast a measly 0.4 per cent annual return. A mean reversion to the long-term average CAPE of 16.6 would indicate a yearly negative 2.8 per cent return over the next decade – ouch!
But what if valuations don’t fall. Research Affiliates touches on what investors could expect but Livermore provides a far more in-depth analysis based on a 7-year US CAPE of 28.3, which excludes the earnings-fallout from the credit crunch. Assuming valuations had been at today’s levels since 1871, Livermore estimates annual returns from the US market would, in real terms, have been about half what was actually achieved over the period (3.95 per cent versus 6.92 per cent per annum) reflecting “what is lost when you reinvest dividends at elevated prices and remove the one-time contribution from secular increases in valuation”.
Assuming inflation of 2 per cent, that’s a nominal return of just under 6 per cent. Livermore points out this is a particular problem for US pension funds, which on average are modelling for annual returns of about 7.5 per cent a year. The yields on bonds makes such returns from that asset class an impossibility, meaning one key hope for pension trustees is likely to be that equities can make a sustained valuation advance from their current level, which is in the 97th percentile since 1871, or the 83rd percentile of the last 20 years.
Livermore suggests that ironically US pensions may have helped create this conundrum as an increase in pension funds’ equity exposure from near zero in the early 1950’s to today’s 70 per cent “is likely to be one of the primary reasons that equities are more expensive”. One could speculate that cheaper international equity markets, like the UK’s, in theory could be beneficiaries of giant US pension funds looking for better returns.
But while the paucity of returns elsewhere may incentivise pension funds to keep piling money into equities, Research Affiliates points out that the demographics of much of the developed world could nevertheless mean pension funds become a source of downward pressure on valuations “over the next 15 to 20 years as valuation-indifferent buyers [saving for retirement] become value-indifferent sellers [funding retirement]”.
Where to find the pieces mentioned:
“CAPE Fear: Why CAPE Naysayers Are Wrong”, Rob Arnott Vitali Kalesnik Jim Masturzo, January 2018
“Future U.S. Equity Returns: A Best-Case Upper Limit”, Jesse Livermore, 17 January 2018