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A caution on the level of the US stock market [ClearOnMoney]
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A caution on the level of the US stock market

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Commentary

A caution on the level of the US stock market

30 Mar 2012 by Jim Fickett.

Shiller's Cyclically Adjusted Price Earnings ratio is currently right about at its 30-year average. However financial returns in recent decades have been driven by ever-increasing leverage, and that era is about over. CAPE is far above its longer-term, and more relevant, average. This is a good time to be very choosy about which stocks you buy.

I have disagreed lately with those who see the US economy stalling, but I should be clear that I am in complete agreement with the pragmatic point many of those same people were making: there is considerable danger in current stock market valuations.

Shares allow you to participate in highly unpredictable future profits, and so the stock market is inherently difficult to value in any precise way. However some valuation methods are better than others and, in particular, even if one cannot set a precise value on a stock, one measure, the Cyclically Adjusted Price Earnings ratio, or CAPE, does give you important information about the likely range of future returns (see Range of stock market outcomes, Yes, the market really is overvalued and Stock Market Valuations Predict Risk and Return; Indicate Poor Returns from Current Levels).

Although the CAPE, currently at 21.9, is far above its long-term average of 16.4 and, using the full history from 1881, suggests poor returns from current levels, some claim the CAPE actually indicates a fairly valued market. Mark Hulbert at Marketwatch interviewed John Campbell, chairman of Harvard's Economics department, and yesterday wrote this:

Campbell, you may recall, was the co-author (with Yale’s Robert Shiller) of the famous paper presented in November 1996 to Alan Greenspan and other Federal Reserve staff suggesting that stocks were entering a bubble phase. This, in turn, led Greenspan to give his now infamous “Irrational Exuberance” speech in December of that year.

I fully expected him to think stocks were, once again, at least within shouting distance of such bubble territory. …

On the contrary, he told me in a recent interview that stocks currently appear to be only “slightly expensive relative to their long-term average.” …

But the CAPE has been higher in recent decades than it was in the latter part of the 19th and early part of the 20th centuries. And when compared to its average level in these most recent decades, the current CAPE level doesn’t appear to be so out of line. In fact, it is only 12% higher than the average level of the last 50 years, and it is right in line with its average level of the last 30 years.

Here is a chart of the CAPE, with the average level since 1881 shown as the red dashed line, the average level since 1963 shown as the orange dashed line, and the average level since 1983 shown as the green dashed line.

Hulbert apparently takes it as obvious that this time is different, and gives no explanation of why more recent decades should be considered the norm. In fact, there is a good reason to think the long-term history is the more relevant one.

That reason is leverage. Bill Gross of Pimco gives a nice explanation in his latest investment letter:

Whether you date it from the beginning of fractional reserve and central banking in the early 20th century, the debasement of gold in the 1930s, or the initiation of Bretton Woods and the coordinated dollar and gold standard that followed for nearly three decades after WWII, the trend towards financial leverage has been ever upward. …

Importantly, this combined fiscal and monetary leverage produced outsized returns that exceeded the ability of real economies to create wealth. …

P/E ratios rose, bond prices for 30-year Treasuries doubled, real estate thrived, and anything that could be levered did well because the global economy and its financial markets were being levered and levered consistently.

And then suddenly in 2008, it stopped and reversed. Leverage appeared to reach its limits with subprimes, and then with banks and investment banks, and then with countries themselves. The game as we all have known it appears to be over, or at least substantially changed – moving for the moment from private to public balance sheets, but even there facing investor and political limits. …

During the Great Leveraging of the past 30 years, it was financial assets with their expected future cash flows that did the best. The longer the stream of future cash flows and the riskier/more levered those flows, then the better they did. That is because, as I’ve just historically outlined, future cash flows are discounted by an interest rate and a risk spread, and as yields came down and spreads compressed, the greater return came from the longest and most levered assets. This was a world not of yield, but of total return, where price and yield formed the returns that exceeded the ability of global economies to consistently replicate them. Financial assets relative to real assets outperform in such a world as wealth is brought forward and stolen from future years if real growth cannot replicate historical total returns. …

What happens when we flip the scenario or perhaps reach the point at which interest rates cannot be dramatically lowered further or risk spreads significantly compressed? The momentum we would suggest begins to shift: not necessarily suddenly or swiftly as fatter tail bimodal distributions might warn, but gradually – yields moving mildly higher, spreads stabilizing or moving slightly wider. In such a mildly reflating world where inflation itself remains above 2% and in most cases moves higher, delivering double-digit or even 7-8% total returns from bonds, stocks and real estate becomes problematic and certainly much more difficult. Real growth as opposed to financial wizardry becomes predominant, yet that growth is stressed by excessive fiscal deficits and high debt/GDP levels..

In other words, a big part of what drove high returns in recent decades was ever-increasing volumes of ever-cheaper money. It is impossible to say exactly when that trend will reverse, but we are certainly near its end. So it is foolish to count on the average value of CAPE staying as high as it has been in the last few decades.