A second shortcoming of relative valuation metrics is the benchmark that is used, typically the metric's long-term historical average. Incorporating the entire history of the U.S. stock market, these metrics have identified an overvalued market for all of the last 20+ years, except for the months spanning the depth of the 2008 global financial crisis. Is it really the case that equity prices were overly optimistic throughout the past two decades, and that the fear and despair in the darkest moments of the crisis corrected the market to "normal" price levels? It seems doubtful. One way to adjust for the higher price levels would be to simply shorten the look-back period in calculating the average, or benchmark, but we view this as an exercise in confirming the story being told (i.e., that the market is not overvalued or has established a new valuation regime).
A more informative approach is to control for the economic climate. A simple example is to use the CAPE while controlling for the level of interest rates and inflation. We've written before about the valuation mountain (Arnott, 2011) that emerges across the spectrum of real interest rates, which we define as the 10-year Treasury yield minus the prior 3-year CPI. When real rates are either low or high, we tend to see low levels of Shiller CAPE. At more moderate levels of real rates, such as between 2% and 5%, higher valuation levels are the norm.
Figure 4, Panel A, is a heat map of the frequency of various CAPE and real interest rate combinations. For example, of the 298 months when real rates were in their lowest quintile, there were only 27 in which CAPE was also in its highest quintile. Compare that to the 116 months—more than four times as frequent—in which CAPE was at its lowest in that low real-rate environment. Follow those blue-tinted boxes as they arc up toward high valuations at moderate real rates and back down again to lower valuations at high rates. This blue arc in Panel A is what we call the valuation mountain.
We currently occupy the box outlined in orange—a higher equity price than might be expected in the current low-rate environment. In fact, prices would have to drop over 37% to reach CAPE levels typically experienced at such low interest rates. Should we expect such a drop over the coming year or two? It's not entirely out of the question, but the average 10-year subsequent returns reported in Panel B tell a different story. Historically, markets have experienced a 3% annual real return in the 10 years following the valuation and rate relationship (high CAPE and low real rate) that we are seeing now. Although a projected annual real return of 3% is lower than the long-term average, it is hardly worthy of panic, provided investors can temper their expectations. It is notable that relatively low real rates are not guaranteed to fuel the stock market and don't seem to have any effect at all unless they are in the bottom quintile. Even then it is difficult to overcome elevated price levels. The bottom line is that all valuation metrics are blunt instruments and should be viewed as such. Relative valuations are important and useful for forming expectations over the long term, but investors should avoid the temptation to use them as a crystal ball.
Price ratios, such as CAPE, have two ways of reverting. The most obvious is via a change in price, which we know can happen quickly and unexpectedly, and the second is via a change in the ratio's denominator—in this case, earnings. Earnings growth, a key component in the absolute valuation models we have described, is also an important consideration in relative valuation models. But because real earnings in the United States are at an all-time high, it is unlikely that growth will be our path off the valuation mountain.