Swedroe: Using Valuation Metrics

April 24, 2019

  • When the CAPE 10 was below 9.6, 10-year-forward real returns averaged 10.3%. In relative terms, that is more than 50% above the historical average of 6.8% (9.8% nominal return less 3.0% inflation). The best 10-year-forward real return was 17.5%. The worst 10-year-forward real return was still a pretty good 4.8%, just 2.0 percentage points below the average and 29% below it in relative terms. The range between the best and worst outcomes was a 12.7 percentage point difference in real returns.
  • When the CAPE 10 was between 15.7 and 17.3 (about its long-term average of 16.5), the 10-year-forward real return averaged 5.6%. The best and worst 10-year-forward real returns were 15.1% and 2.3%, respectively. The range between the best and worst outcomes was a 12.8 percentage point difference in real returns.
  • When the CAPE 10 was between 21.1 and 25.1, the 10-year-forward real return averaged just 0.9%. The best 10-year-forward real return was still 8.3%, above the historical average of 6.8%. However, the worst 10-year-forward real return was now -4.4%. The range between the best and worst outcomes was a difference of 12.7 percentage points in real terms.
  • When the CAPE 10 was above 25.1, the real return over the following 10 years averaged just 0.5%—virtually the same as the long-term real return on the risk-free benchmark, one-month Treasury bills. The best 10-year-forward real return was 6.3%, just 0.5 percentage points below the historical average. But the worst 10-year-forward real return was now -6.1%. The range between the best and worst outcomes was a difference of 12.4 percentage points in real terms.

What can we learn from the preceding data? First, starting valuations clearly matter, and they matter a lot. Higher starting values mean that not only are future expected returns lower, but the best outcomes are lower and the worst outcomes worse. And the reverse is true as well—lower starting values mean that not only are future expected returns higher, the best outcomes are higher and the worst outcomes less poor.

However, it’s also extremely important to understand a wide dispersion of potential outcomes, for which we must prepare when developing an investment plan, still exists—high (low) starting valuations don’t necessarily result in poor (good) outcomes. In other words, investors should not think of a forecast as a single point estimate, but only as the mean of a wide potential dispersion of returns.

The reason for the wide dispersion, as Damodaran noted, is mostly that risk premiums are time varying (if they were not, there would be no risk in investing!). It is the time-varying risk premium, what John Bogle called the “speculative return,” that leads to the wide dispersion in outcomes.

Dealing With Dispersion

The fact that a wide dispersion of returns occurs around the mean forecast is why a Monte Carlo simulation is a valuable planning tool. While the input includes an estimated return, it recognizes the risks of that mean forecast not being achieved—which is why volatility is another input.

Because most simulators allow you to examine thousands of alternative universes, they allow you to test the durability of your plan—you can see the odds of success (such as not running out of money, or leaving an estate of a certain size) across various asset allocations and spending rates.

The time-varying risk premium is also why an investment plan should include a Plan B, a contingency plan that lists the actions to take if financial assets were to drop below a predetermined level. Actions might include remaining in, or returning to, the workforce, reducing current spending, reducing the financial goal, selling a home and/or moving to a location with a lower cost of living.

The bottom line is that 40% explanatory power provides significant information that investors can use to build plans. However, you must not make the mistake of overestimating the forecasting power of the CAPE 10 metric and treat that forecast as what will happen. Instead, it should be used to help determine your need to take risk and then, with the understanding that risk premiums are time varying and a wide dispersion of potential outcomes is likely, to help build a Plan B.

Another mistake that investors make when criticizing the use of the CAPE 10 is that it doesn’t work as a timing tool.

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