Swedroe: Seeing Valuations Clearly

February 05, 2018

In theory, higher earnings retention should result in faster earnings growth as firms reinvest that retained capital (or buy back shares). That has been the case for this particular period. From 1954 to 1995, the growth rate in real earnings per share averaged 1.7%; from 1995 to 2017, it averaged 3.3%.

To make comparisons between present and past values of the CAPE 10, any differences in payout ratios must be normalized. The adjustment between the 52% payout ratio (the average from 1954 through 1995) and the 35% payout ratio (the average from 1996 through 2017) corresponds to approximately a 1-point difference on the CAPE 10. Using the current payout ratio would lead to a smaller adjustment of about 0.5.

Nothing Magical About The CAPE 10

In their classic 1934 book, “Security Analysis,” Benjamin Graham and David Dodd noted that traditionally reported price/earnings ratios can vary considerably because earnings are strongly influenced by the business cycle. To control for cyclical effects, they recommended dividing price by a multiyear average of earnings, and suggested periods of five, seven or 10 years.

Then, in a 1988 paper, economists John Campbell and future Nobel Prize-winner Robert Shiller, using a 10-year average, concluded that a long-term average provides information in terms of future returns. This gave further credibility to the concept, and led to the popular use of the CAPE 10 ratio.

However, as Graham and Dodd observed, there’s really nothing special about using the 10-year average. Other time horizons also provide information on future returns. With that in mind, I’ll analyze how changing the horizon can impact our view of the market’s valuation.

While the current CAPE 10 is about 34, the current CAPE 8, which has approximately the same explanatory power as the CAPE 10 but excludes the very bad and temporarily depressed earnings figures from 2008 and 2009, is about 31.

If we use the CAPE 8 of 31, and then make the adjustments for accounting changes and dividend reduction, we get what we might call an adjusted CAPE 8 of about 26. That provides a real return forecast of 3.8%, close to 1 percentage point higher than when using the current CAPE 10. That’s the good news. The bad news is that it still leaves you with an expected U.S. stock return well below historical levels, and probably well below the expectations of most investors.

There’s one more issue we need to cover.

Highly Valued Not The Same As Overvalued

While even a CAPE 10 ratio of 26 would be historically high (the long-term mean of the CAPE 10 is about 17), that doesn’t necessarily mean the market is overvalued—just highly valued, with lower expected returns. Let’s see why that is the case.

The 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 make the world a safer place for investors, justifying a lower equity risk premium and thus rising valuations. In addition, we have not experienced another Great Depression, and there haven’t been any worldwide wars since 1945.

Another reason for the CAPE 10 rising over time is that the U.S. has become a much wealthier country since 1880. As wealth increases, capital becomes less scarce. All else equal, less scarce assets should become less expensive. The data supports this hypothesis.

A third reason for a rising CAPE 10 is that 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.


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