..In yesterday’s newsletter I outlined some of the dangers facing the world of finance. We need to ask if the dangers have arisen in a time of modest asset prices and therefore there is some resilience in the system to absorb such shocks? Or are they hitting us at the point when markets are priced for perfection, e.g. investors price shares on the basis that the Fed will serenely calm down inflation without upsetting anybody by say raising unemployment, an “immaculate deflation”.
Analogy: The film The Italian Job ends with the bus full of gold teetering on the brink. All it needs is for a trigger such as an ounce of extra weight at the wrong end of the bus for it to plunge into the ravine.
So the question for us today is whether we focus on the trigger or we focus on the factors that led to a precarious position?
Of course, when the trigger arrives - say the shutdown of one-quarter of China’s factories - all attention will be on that trigger. But the trigger is only one-tenth of the story; it wouldn’t matter so much if markets are modestly priced now - if Wall Street was not priced for perfection.
We need to focus on the level of resilience (are we on rock solid ground or teetering on the brink?) especially when there are so many potential triggers out there. That brings us the CAPE.
Benjamin Graham made great use of the cyclically adjusted price earnings ratio, CAPE, to judge, in a rough and ready way, whether a company was grossly over or under-priced.
Robert Shiller of Yale university built on the idea of looking at asset prices relative to earnings over a full economic cycle by calculating the CAPE for the American stock market as whole for every month going back to 1881.
His data has been used by people to get a first approximation to whether we have “high” or “exuberant” markets, or “low…depressed” markets.
Thus, if the CAPE is at say 30 the average share is 30 times the average annual earnings of the companies it represents when averaged over the previous 120 months.
A better way of thinking about that is the average share offers a 3.3% earnings yield. This is on the assumption that earnings in future years will be the same as the average over the last decade.
Of course, at times like these the optimists come to the fore and declare that it is OK to pay 30 times average earnings because profits are on an upward trajectory, “soon they will be double the historical level” and so the one-year PER, at least, will fall to “only” 15, an earnings yield of 6.7%. So that’s OK. Times are good and earnings will double, won’t they? And 6.7% earning yield is a good return, isn’t it, even for the risk we run by holding the risk capital assets called shares”?
Well, history has shown us that people have a remarkable propensity to shift mood. They can start to think that far from earnings doubling they will actually keep falling year after future year.
And far from thinking 6.7% is a good return they think that it’s far too little given higher inflation and given the terrible risk they face with shares, where you can lose 20%, 50% or 70% in a short period – many people are already starting to think “I lost 25% on my US tech stocks over the last six months. Of course, shares are risky. Give me more return or I’ll sell them.”
This shift to a negative mood in the past has resulted in stock market participants being so fed up that the CAPE on the averagely risky US fell to 8, or even as low as 6.
Evidence of CAPE’s usefulness
But enough of moods. What of the evidence of the usefulness of the CAPE in predicting future markets. The academic work on the aggregate market CAPE shows that if you allocate each year of stock market history to one of ten categories depending the level of CAPE, so the top decile contains the one-tenth of years with the highest CAPEs and the bottom decile the one-tenth with the lowest CAPEs, then a remarkable result is shown for stock market performance in subsequent years, at least on average over a large sample.
For example, in the study conducted by Rui Antunes the return from the high decile CAPE stocks (using the world index) over the next year was -4% whereas that from the lowest CAPE decile was +21%. Now, this was one study over one time period so caution is needed. But the results do fit into a general pattern in the literature.
The CAPE is far from a “perfect predictor”: in 1997, for example, and again in 2018, the US CAPE was very high and yet shares went up the following year.
While not a perfect predictor we can conclude that in general terms if the CAPE is very high shares have an increased probability of falling over the next few months or years, or at least providing a poor return.
Some past extremes
In September 1929 the US stock market reached a CAPE of 32.6, a peak it wasn’t to surpass for another 68 years.
Come June 1932 investor mood, not helped by the economic environment, had shifted so much that investors were willing to pay an average CAPE of only 5.6. In other words, as investors looked back at ten years of earnings (1922 – 1931) they thought either that the next ten will be worse or that, because of the increased perceived risk, they’ll demand a 18% (1/5.6) earnings yield based on the previous decades’ earnings.
For a couple of generations investors were so fearful of equities that they kept the US CAPE low. The next peak did not come until 1969 when it rose to 22.3. That was thought by many at the time to be a wildly optimistic valuation.
Then the downturn came in the 1970s pushed by stagflation. The CAPE fell to 8.3 in 1974. This came about through massive share price falls. (It created many opportunities for value investors).
The market recovered and by the 1980s one-year PERs and the ten-year CAPEs were back into double figures.
Later a mania for dotcom stocks chan.........
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