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Yes, the market really is overvalued [ClearOnMoney]
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Yes, the market really is overvalued

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Commentary

Yes, the market really is overvalued

23 Jun 2011 by Jim Fickett.

The Cyclically Adjusted Price Earnings ratio stands at 22.0, compared to a long-run historical average of 16.3. Unlike many valuation measures, the CAPE actually has predictive value, and the current value suggests 7-year annualized returns of only about 3.6%, and odds of 24% for an actual loss. This is a good time to buy only individual stocks with clear value, and to wait for better opportunities.

Robert Shiller's Cyclically Adjusted Price Earnings ratio (CAPE) is the ratio of the S&P composite to the 10-year average of its inflation-adjusted earnings. It currently stands at 22.0 (with the tentative June value using data through the 16th). This compares to a long-run historical average of 16.3. Here is a graph:

(The dashed red line shows the average. Click for larger image.)

The graph makes it clear that, barring the tech bubble, the current value of CAPE is comparable to that at past stock market tops. So what?

Well, unlike many other valuation measures, CAPE actually tells you something valuable about future returns.

Rich Toscano has recently provided the nicest overview of CAPE that I've seen, on the Pacific Capital Associates blog.

First, Toscano shows that 7-year inflation-adjusted returns depend very strongly on the value of CAPE at the starting point. For example, with the present value of 22.0, expected 7-year real returns are about 28% (3.6% annualized). When CAPE is only slightly higher we are bumped into the next category and expected returns fall to only about 6% (0.8% annualized). Compare that to expected returns of 90%+ when CAPE is under 11.

Second, he shows that the risk of a substantial loss is much higher when CAPE is high. For example, with the current valuation, one can expect an actual loss, after 7 years, about 24% of the time. With even slightly higher values of CAPE, that rises to 40%.

And third, Toscano takes a long list of objections commonly made against the conception or application of CAPE, and answers them one by one. In my view, the most substantial objection to CAPE is that it matters quite a lot what starting point in time you use for your analysis – if you use a short history that includes the 1999 peak, current values of CAPE don't look extreme. Could it be that stock valuations are permanently higher now than they were before? This question cannot be answered with certainty, but there is good reason to think that, as usual, “this time is different” is a very dangerous premise:

“What if there has been a permanent shift upward in valuations, such that it's inappropriate to compare current valuations with those of decades past?”

Interestingly, for all the complaints about the CAPE, we haven't read this argument elsewhere. But when we discuss amongst ourselves the CAPE's ability to continue to predict returns, this is the one that troubles us the most. The phrase “it's different this time” is very deservedly the bane of value investors everywhere. And yet, once in a great while, there are very long-term shifts in relationships between prices and some of the fundamentals that underpin them. (The seemingly permanent shift downward in the US stock market's dividend yield starting in the late-1950s would qualify as one such example, in our opinion).

Might this be one of those times? Have investors come to accept a permanently higher valuation for stocks? One can't rule it out, but in our opinion, this isn't likely. With the benefit of hindsight, we can identify some factors that very likely contributed to the market's unusually heightened CAPE valuation over the past two decades. These include the following:

  • The 1978 birth of the 401K, which likely helped to direct a lot more savings into the stock market.
  • A secular decline in interest rates (remember, investors tend to accept higher stock valuations when rates are lower, even if it's a bad idea to do so).
  • An enormous increase in borrowing, which financed more economic activity than there would have been in the absence of such borrowing.

For those who would use these factors to justify a New Era of higher valuations, the problem is that none of these factors are permanent – and some may be about to go into reverse:

  • Retiring boomers will soon start draining their 401ks.
  • We believe that interest rates are likely to rise substantially in the years ahead.
  • We also believe that the US will soon enough hit a point at which it is forced to stop adding to its debt and start reducing it.

The last issue is particularly troubling in terms of future valuations. If values were higher than usual due to all our borrowing, then they might become lower than usual when we stop increasing our net borrowing and start to pay all that debt down. And a bond market crisis, should it come to that, would certainly not be good for stocks. If anything, the risks posed by our fragile debt situation would imply a lower valuation than usual, rather than the unusually high valuation currently in place.

I would add one point here. Investor psychology now includes confidence in the so-called “Greenspan put”, the idea that the Fed will always rescue the market. And indeed, the Fed will continue to desire to rescue the market. However whether it will continue to be able to do so is another question. If investors eventually lose faith in Treasuries, as I think will happen in 5-10 years, then the Fed will no longer be able to keep interest rates low.

All in all, the CAPE strongly suggests caution in the current market.