Swedroe: Valuations Too High?

I’ve recently discussed investor concerns related to fallout from a global trade war and to a potential inversion of the yield curve. Today I’ll discuss a third concern on many investors’ minds: the high valuations of U.S. equities.

Before delving into the issue, it’s important to note that, while U.S. equity valuations are well above their long-term historical averages, valuations of international equities are both lower and closer to their historical averages.

For example, as of June 30, 2018, the earnings yield (E/P) of the Shiller CAPE 10 (the best predictor of future real returns we have) for the U.S. was just 3.2%. It was 5.2% for non-U.S. developed markets and 6.6% for emerging markets (data provided by AQR Capital Management).

With the CAPE 10 currently at about 33, more investors are worried about the outlook for future equity returns and the possibility of mean reversion in valuations, which could lead to a bear market. Jeremy Grantham, the highly regarded chief investment strategist at GMO, has been warning investors about this scenario since 2013, when he declared all global assets were once again becoming “brutally overpriced.”

We know today that the market ignored Grantham’s warning. Instead of collapsing, from February 2013, when Grantham made the preceding assertion, through June 2018, the S&P 500 Index posted a total return of 103% and an annualized return of 14%, almost 40% above its long-term average of 10.1%.

If you were inclined to believe that such high valuations meant U.S. stocks were doomed to a bear market, Crescat Capital’s third quarter 2017 investor letter provided plenty of acid for your stomach. The letter began by noting, “US large cap stocks are the most overvalued in history, higher than prior speculative mania market peaks in 1929 and 2000.”

Crescat’s Warning

The authors of the Crescat letter went on to “prove it conclusively” by showing various valuation metrics related to price-to-sales (P/S); price-to-book (P/B); enterprise value-to-sales (EV/S); enterprise value-to-earnings before interest, taxes, depreciation and amortization (EV/EBITDA); price-to-earnings (P/E); and enterprise value-to-free cash flow (EV/FCF).

They then noted—and recall this was in November 2017—that, “Brutal bear markets and recessions have historically followed from record valuations like we have today, and this time will almost certainly be no different.” They also noted:

• The median P/S ratio for the S&P 500 at the time was the highest ever, by a wide margin: more than 60% greater than the tech bubble peak.
• S&P 500 companies were more leveraged than ever before, and this was true for the entire corporate world.
• The median EV/S for the S&P 500 was at a record level.
• The median EV/EBITDA for the S&P 500 was at a record level.
• Profit margins were at all-time, unsustainable highs, and surges in profit margins occur at the end of the business cycle, before bear markets. A margin-adjusted measure of the CAPE 10 increased it to 43—greater than the ratio’s 41 in 1999 and 40 in 1929. The margin-adjusted CAPE 10 predicted negative average returns for the following 12 years (John Hussman developed this measure).
• The median cyclically adjusted EV/FCF for nonbanks in the S&P 500 was an insanely high 41, the highest ever.

The letter went on to add that, while P/E multiples tend to be higher when inflation is at low, positive levels, multiples (at the time) were among the highest P/Es ever for a 2% inflation environment. They suggested that “we could see a 50% decline in stock prices just to get back to mean historical P/E multiples for this level of inflation.”

They then added that they saw the Federal Reserve’s tightening of credit (both raising interest rates and unwinding its balance sheet) as the main catalyst that will burst global asset bubbles.

If you were already worried about the aforementioned risks of a global trade war and an inverted yield curve, Crescat’s quarterly letter, had you read it, might have provided the tipping point leading to panicked selling. The market continues to ignore such clarion calls. For the nine-month period from October 2017 through June 2018, the S&P 500 Index ignored Crescat’s warning and provided a total return of 9.5%.

Looking Through The Proper Lens

It’s important to understand that when it comes to future expected returns, valuations not only matter, they matter a great deal. The reason, as noted above, is that current valuations are the best predictor we have of future returns. However, it’s equally important to understand there is a huge difference between highly valued (future returns are likely to be below historical returns) and overvalued. Let’s see why that is the case.

CAPE 10 data goes back to 1880. It includes economic eras in which the world looked very different (much riskier) to investors than it does today. Consider 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.

Another logical explanation for a rising CAPE 10 is that economic volatility has fallen dramatically since 1880. While the U.S. had experienced many panics and depressions (1807, 1815-21, 1837, 1857, 1873, 1893, 1907, 1920-21) prior to the Great Depression of the 1930s, there has not been even one of such a magnitude since. There also haven’t been any worldwide wars since 1945.

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

A fourth reason for a generally 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.

Over time, the cost of liquidity, in the form of bid/offer spreads, has dramatically decreased. There are several reasons for this, including the decimalization of stock prices and the provision of greater liquidity by high-frequency traders. In addition, the cost of commissions has collapsed. Furthermore, other implementation costs—in the form of index funds and ETFs’ much lower expense ratios—also have fallen, meaning investors are capturing more of the gross return to stocks, justifying higher valuations (which, in turn, leads to lower expected returns).

There’s yet a fifth explanation for rising equity valuations, and it’s simply that the capital share of output has risen, while the labor share has fallen.

Upward Drift

The preceding reasons help explain why the long-term median of the CAPE 10 has drifted upward. While the CAPE 10’s mean has been 16.9 over the entire period since 1880, from 1960 through April 2018, a period of more than 58 years, the mean has been 20.1. Since 1970, the mean has been 20.0. Since 1980, the mean has been 21.9. Since 1990, a period of almost 30 years, it has been a much higher 25.6.

When people state there is a risk that valuations revert to their mean, which mean should we expect them to revert to? The one that includes very different (and much riskier) economic and regulatory regimes? That’s comparing apples to oranges. Perhaps we should expect reversion to the mean over the more recent period beginning in 1990?

Summarizing, the important point is that if higher valuations are justified by systematic changes making equity investing less risky/less costly, while they may be forecasting lower future returns, they are not necessarily signaling overvaluation. With the 10-year TIPS (a benchmark for the riskless rate of return for a long-term investor) at about 0.8%, and the CAPE 10 forecasting a 3.2% expected real return to U.S. stocks, we have an equity risk premium against that benchmark of about 2.4 percentage points.

No one knows if that is an appropriate return or not for the risk of investing in equities; it’s just lower than the long-term historical average return. In any case, we are not done with our analysis.

Accounting Rules Have Changed

In 2001, the Financial Accounting Standards Board changed the rules regarding how goodwill is written off. As a post on the blog Philosophical Economics explained, “In the old days, GAAP required goodwill amounts to be amortized—deducted from earnings as an incremental non-cash expense—over a forty-year period. But in 2001, the standard changed. FAS 142 was introduced, which eliminated the amortization of goodwill entirely. Instead of amortizing the goodwill on their balance sheets over a multi-decade period, companies are now required to annually test it for impairment. In plain English, this means that they have to examine, on an annual basis, any corporate assets that they’ve acquired, and make sure that those assets are still reasonably worth the prices paid. If they conclude that the assets are not worth the prices paid, then they have to write down their goodwill. The requirement for annual impairment testing doesn’t just apply to goodwill, it applies to all intangible assets, and, per FAS 144 (issued a couple months later), all long-lived assets.”

While FAS 142 may have introduced a more accurate accounting method, it also created an inconsistency in earnings measurements. Present values end up looking much more expensive relative to past values than they actually are. And the difference is quite dramatic. Adjusting for the accounting change would put the CAPE 10 about 4 points lower, to under 29.

Still another reason not to rely on the CAPE 10’s long-term historical mean as a yardstick for valuations is that there has been a dramatic change in dividend policy, with fewer companies paying dividends now than in the past.

For example, in the 2001 study, “Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?”, Eugene Fama and Kenneth French found that firms paying cash dividends fell from 67% in 1978 to 21% in 1999. That percentage is likely higher today, as the number of public companies has fallen by almost a half, with most of the decline coming from very small companies, which tend not to pay dividends.

That said, the dividend payout ratio for S&P 500 companies dropped from an average of 52% from 1954 through 1994 to an average of just 35% from 1995 through 2017. It was at 40% as of year-end 2017.

In theory, higher retention of earnings should result in faster growth of earnings as firms reinvest that retained capital (or buy back their 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% and, from 1995 through 2017, it averaged 3.3%.

As the post on Philosophical Economics explained, to make comparisons between present and past values of the CAPE 10, differences in payout ratios must be normalized. The adjustment between the 52% payout ratio (the average from 1954 through 1994) and the most recent payout rate corresponds to approximately a 0.5 difference in a CAPE 10 ratio. Obviously, the impact of the lower payout ratio is a relatively small one, but it should not be totally ignored. There’s one more issue to consider.

No Magic To 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 U.S. CAPE 10 is 33, the current CAPE 8—which has about the same explanatory power as the CAPE 10 but excludes the very bad and temporarily depressed earnings figures from 2008 and 2009—is 5 points lower at 28. (Comparable figures for non-U.S. developed and emerging markets are about 19 and 15, respectively.)

That’s not all that much higher than the CAPE 10’s mean of 25.6 from 1990 through April 2018. A CAPE ratio of 28 results in an earnings yield of 3.6%, while a CAPE ratio of 25.6 results in an earnings yield of 3.9%. That’s not much of a difference. It is also just 1 percentage point lower than the average CAPE 10 earnings yield of 4.6% for the period starting from 1980. There’s no way to know if that is the right earnings yield.

Additionally, if we use the CAPE 8 of 28, and make the adjustments for the accounting changes and the reduction in dividends, we get what we might call an adjusted CAPE 8 of about 23.5. That provides a forecast for real returns of about 4.3%, or about 1 percentage point higher than the real return forecast using the current CAPE 10. That’s the good news. The bad news is that it still leaves you with expected U.S. stock returns well below historical levels, and probably well below the expectations of most investors.

Summary

The concern about future returns is justified by the fact that, while academic research shows valuations are a very poor forecaster of stock returns in the short term, they are the best predictor we have of long-term returns.

The bottom line is that today’s high valuations, while signaling investors should expect future equity returns to be significantly lower than past returns (bond yields are much lower than historical levels, creating a challenge for overall portfolio returns), don’t necessarily mean the market is overvalued. They also don’t mean that you should be acting on warnings from “market gurus” about the virtual certainty of an impending bear market.

The history of markets, and evidence regarding the inability of forecasters to correctly time the market, tells us we should make sure our plans include the virtual certainty that we will continue to experience severe bear markets (we’ve had three in the past 45 years). However, trying to time markets based on valuations, or anything else, is a loser’s game. Just ask those listening to Jeremy Grantham’s predictions of doom for the past five or more years.

Instead, listen to Warren Buffett’s advice on the subject: “We have long felt that the only value of stock forecasters is to make fortune-tellers look good. Even now, Charlie (Munger) and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”

For a financial plan to have a high likelihood of success, it’s important that expected return estimates used in the plan are appropriate given current valuations. If your estimated expected returns are much higher than we discussed, it increases the chance you won’t achieve your financial goals. If that is the case, you should adapt your plan to reflect the current reality. For example, you might decide you have to increase your savings rate (cut current spending).

Alternatively, you could decide to lower your spending goals in retirement, or plan on working longer. Or perhaps you might plan on moving to a lower-cost-of-living area. There are other options you can consider, such as increasing your allocation to higher-expected-returning equities like international and emerging market stocks (with their lower valuations) or small and value stocks. All would increase the estimated expected returns of your portfolio, giving you a greater chance of achieving your goals.

Finally, a word of caution: Because bear markets are virtually inevitable, someday some guru will be given credit for successfully predicting the timing of one, and you’ll see that person on all the talk shows. Of course, pigs will fly before the media provides you with a full list of all their forecasts, as that would spoil the game.

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