Swedroe: This Metric In Dire Need Of Context

July 14, 2017

In addition, we can look at a metric that considers the competition with corporate bonds. The current earnings yield/price minus the yield on Baa corporate bonds is 1.3%, while the 25-year average is -0.3%. Using this metric, stocks look cheap relative to corporate bonds, and are 0.8 of a standard deviation undervalued. There just doesn’t seem to be a compelling case that the U.S. market is overvalued.

This brings us to the next question: How did the S&P 500 perform over this 25-year period when valuations were not too dissimilar from their current level? From June 1992 through May 2017, on an annualized basis, the S&P 500 returned 9.5% before inflation and 7.2% after inflation. That’s right in line with the long-term data.

Quirks In The CAPE 10
However, we still need to address the issue with the current level of the CAPE 10, which historically has been as good a predictor of future returns as current valuations (and those are the two best predictors we have). Before you make a decision, it’s important to understand there are several issues with the CAPE 10 you must be aware of when considering whether it’s signaling overvaluation.

As noted earlier, the current level of the CAPE 10 is close to 30. This compares to a long-term (137-year) average of 16.7. This wide gap is what has led many observers to conclude that the market is overvalued and headed for a sharp decline.

In finance, it’s generally best to look at the longest data series available, thereby minimizing the risk of data mining. But there are several reasons using a 137-year average for the CAPE 10 could lead to a false conclusion.

We’ll begin by noting that the data set for the Shiller CAPE 10 goes all the way back to 1880. The data includes economic eras in which the world looked very different to investors than it does today.

Consider just two examples. For a significant part of the period, there was neither a Federal Reserve to dampen economic volatility nor an SEC to protect investor interests. Both of these organizations have helped to make the world a safer place for investors, justifying a lower equity risk premium and thus rising valuations.

Additionally, we have not experienced another Great Depression, and there haven’t been any worldwide wars since 1945. While those rising valuations forecast lower future returns, they aren’t necessarily signaling overvaluation.

Another reason for the CAPE 10 rising over time is that the U.S. has become a much wealthier country since 1880. This matters because, as wealth increases, capital becomes less scarce. All else equal, less scarce assets should become less expensive.


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