As we approach the end of 2016, the Shiller CAPE 10 stands at about 28, a level rarely exceeded (with the exception of in the late-1990s technology-driven bull market). Such heights cause many investors to worry about what current valuations may mean for future expected returns.
I’ll try to provide some insights by reviewing the literature, which demonstrates a link between current valuations and expected returns. We’ll also examine a new paper that takes a different look at the subject.
In the 2013 edition of his paper “Equity Risk Premiums (ERP): Determinants, Estimation and Implications,” Aswath Damodaran explored three approaches for estimating equity returns: the historical approach, a survey approach and a current valuation approach.
Historical Vs. Survey Approaches
Damodaran, a professor of finance at New York University’s Stern School of Business, explained the problem with the historical approach: “When stock prices enter an extended phase of upward (downward) movement, the historical risk premium will climb (drop) to reflect past returns. Implied premiums will tend to move in the opposite direction, since higher (lower) stock prices generally translate into lower (higher) premiums. In 1999, for instance, after the technology-induced stock price boom of the 1990s, the implied premium was 2% but the historical risk premium was almost 6%.”
He then explained the problem with using the survey approach: “Survey premiums reflect historical data more than expectations. When stocks are going up, investors tend to become more optimistic about future returns and survey premiums reflect this optimism. In fact, the evidence that human beings overweight recent history (when making judgments) and overreact to information can lead to survey premiums overshooting historical premiums in both good and bad times. In good times, survey premiums are even higher than historical premiums, which, in turn, are higher than implied premiums; in bad times, the reverse occurs.”
Finally, he provided the following insight about the valuation approach: “When the fundamentals of a market change, either because the economy becomes more volatile or investors get more risk averse, historical risk premiums will not change but implied premiums will. Shocks to the market are likely to cause the two numbers to deviate. After the terrorist attack on the World Trade Center in September 2001, for instance, implied equity risk premiums jumped almost 0.50% but historical premiums were unchanged (at least until the next update).”
To determine the “right” approach, Damodaran studied the predictive powers of each, looking at their returns during the following 10-year period. His study covered the period 1960 through 2012. He found the correlation of the current implied premium with returns over the next 10 years was +0.43. On the other hand, the correlation of the historical premium with the returns over the next 10 years was in the wrong direction—negative 0.48.