Swedroe: Valuations Too High?

August 08, 2018

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.


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.

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