The S&P 500 has returned a cumulative 250% from the bear-market bottom in March 2009 through November 2015. Six and a half years into the current bull market, investors are concerned that valuations may be getting rich. At first blush, one of the market’s more-popular valuation metrics seems to be corroborating these concerns. A more careful analysis indicates that this may be a false alarm, though not necessarily an all-clear.
One popular gauge of stock market valuation is the cyclically adjusted price/earnings ratio (CAPE) also known as the Shiller P/E. Yale University professor Robert Shiller popularized the measure in his book, Irrational Exuberance.1 The CAPE divides the level of an equity index by the reported earnings of its constituents averaged over the trailing 10 years. As of this writing, the CAPE for the S&P 500 is 26. This is well above its median value of 16 since 1881. Some fear this is a sign of a market bubble and portends lower future returns. But there are several fundamental and technical factors that currently support an above-average CAPE. While valuations may still be somewhat elevated after accounting for these issues, it is clear that the current situation is less dire than a quick glance at a single measure of valuation would lead one to believe.
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The Flaw(s) of Averages
There is no theory that says that 1881 is the best starting point for this data set. That just happens to be the earliest point at which Shiller could compile all the necessary data to produce the CAPE. Generally speaking, more data is better. That said, the further a data set extends into the past, the less likely it is that information will be both reliable and relevant to today. For example, if we choose 1954 as a starting point and end our analysis in September 2010, the median value for the CAPE was about 18—meaningfully higher than the full-period result of 16. A stopping point in 2010 allows us to compare the level of the CAPE to returns over the subsequent five years.
Since 1954, when the CAPE was above 18, the inflation-adjusted average five-year forward annualized return on the S&P 500 was 4.7%. Compare 7.5% when the CAPE was below 18. Exhibit 1 shows historical CAPE ranges and the corresponding five-year forward returns, which are annualized and inflation-adjusted, for the S&P 500. In light of the data, the fact that the CAPE now stands well above 19 seems to suggest that future returns will be below average.
The correlation between the CAPE and inflation-adjusted average five-year annualized returns is negative 43%. The relationship is strong, but it is not deterministic. While the CAPE cannot go higher forever, there is nothing that says that it must revert to its long-term average. Certainly we do not expect the CAPE for individual stocks to always mean-revert, so why should the market as a whole mean-revert around an average CAPE?
Since 1954, the CAPE ranged between 24 and 28 in 74 months. Starting from those months, the average five-year forward return for the S&P 500 was just 1%. But this average belies the range of subsequent returns that we’ve witnessed once the CAPE has hit these lofty levels. The worst five-year stretch began in February 2004, when the CAPE hit 27.65. The S&P 500 subsequently fell by 9% annualized during the next five years. The best five-year period began in November 1995 when the CAPE hit 24.35. The S&P 500 went on to gain 15% annualized over the next five years as the tech bubble inflated.
Looking at a chart of the CAPE, there is a clear trend higher. Since 1992, the CAPE has been below 18 in just 10 out of 226 months, all of which occurred during the market nadir in the midst of the Great Recession. From 1954 to 1992, the median CAPE was 16. From 1992 to 2010, the median CAPE was 25. What could account for this trend?
In part 2 of this article, we will look at the fundamentals behind the CAPE.
1Shiller, R. 2000. “Irrational Exuberance.” (Princeton: Princeton Univ. Press).
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