Swedroe: Valuation Metrics In Perspective

November 11, 2015

Moreover, trading costs today are much lower, and the expense ratios of mutual funds and ETFs are much lower as well. All of these “regime changes” should lead to the equity risk premium demanded by investors migrating lower. Since 1960, the mean of the CAPE 10 has been about 20. It’s also been about 20 since 1970, and above 21 since 1980. If you are expecting mean reversion, perhaps a mean of 20 is a more appropriate one at which to be looking.

And there have been accounting changes, which, while providing a better measure of earnings, also make current valuations look much higher than they actually are relative to past valuations. It’s estimated that adjusting for accounting changes (FAS 142 and 144, which have to do with the writing off of intangible assets) would push the current CAPE 10 down by about 4 points.

Additionally, dividend payout ratios are much lower, which should lead to higher earnings growth, justifying higher valuations. Adjusting for that would change the CAPE 10 downward by another 1 point.

Using the CAPE 10’s average of 20 since 1960, and adding the adjustments for the accounting changes and dividend payout ratios, brings us to an adjusted CAPE 10 of about 25, which is right about where it is now. And finally, cash on corporate balance sheets is above the long-term average, and debt ratios are below it.

Comparing valuations across time without taking the above factors into account is a mistake, because more cash and lower debt ratios make equities less risky, and justify higher valuations. Thus, even if you believed in some magical reversion to the mean of the CAPE 10, when viewed through the proper lens, it doesn’t really look overvalued at all, just highly valued.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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