In theory, higher retention of earnings should result in faster growth of earnings as firms reinvest that retained capital. That has been the case for this particular period; from 1954-1995, the growth rate in real earnings per share (EPS) averaged 1.72%, and from 1995-2015, it averaged 4.9%.
As the post on Philosophical Economics explained, to make comparisons between present and past values of the Shiller CAPE 10, any differences in payout ratios must be normalized. The adjustment between the 52% payout ratio (the average from 1954-1995) and the 34% payout ratio (the average from 1995-2015) corresponds to approximately a one-point difference on the Shiller CAPE 10.
The Liquidity-Risk Premium
And there’s yet another reason why the long-term mean of the CAPE 10 might be misleading. Investors demand a premium for taking liquidity risk (less-liquid investments tend to outperform more liquid investments).
All else equal, investors prefer greater liquidity. Thus, they demand a risk premium to hold less-liquid assets. Over time, the cost of liquidity, in the form of bid/offer spreads, has decreased. There are several reasons for this, including the decimalization of stock prices and the provision of additional liquidity by high-frequency traders. In addition, commissions have collapsed in price.
But we aren’t done quite yet. Another important factor is that the presence of financial instruments that allow investors to buy and sell illiquid assets indirectly (such as index funds and ETFs) work to lower the sensitivity of returns to liquidity. These instruments enable investors to hold illiquid stocks indirectly with very low transaction costs, reducing the sensitivity of returns to liquidity. With these innovations in markets, all else equal, we should see a fall in the equity risk premium demanded by investors, and thus higher valuations.
If we make an adjustment from a CAPE 10 to a CAPE 6 or CAPE 5, and we use a still very long period of 56 years and operating earnings, we find the current valuation of the market is less than 20% above its mean. That’s a dramatically lower figure than the 57% difference between the current CAPE 10 and its long-term average.
What’s more, even the 20% difference doesn’t consider adjustments for any of the issues we raised, including the changes in accounting rules, the reduction in the tendency to pay dividends and the dramatic fall in transactions costs.
The bottom line is that once those adjustments are considered, there’s a case to be made that the market no longer looks overvalued. However, that doesn’t mean expected returns aren’t lower than the historical average. If we use the CAPE 6 of 18.7, that results in an earnings yield of 5.3%.
However, since earnings grow over time, we still have to account for an average lag of three years. I suggest using a real earnings growth forecast of 2%. Thus, we need to multiply 5.3% by 1.06 (1 + [3 x 2%]), producing an adjusted earnings yield of 5.7%. And that would be the forecast for future real returns for the S&P 500.
If we use the CAPE 5 of 18.5, we get an earnings yield of 5.4% and multiply that by 1.05 (1 + [2.5 x 2%]), which produces a slightly higher real expected return of 5.7%. In either case, that remains well below the historical 7% real return, but not as bad as the forecast of 4.2% you get from using the CAPE 10 figure of 26.3.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.