I read an interesting article by Dr. Jeremy Siegel in the May/June edition of the Financial Analysts Journal. I think there are two important takeaways to consider for all investors:
1) The stock market might not be as overvalued as every news media source would have you believe
2) Even if the stock market is overvalued, that might not have much bearing on your long-term future returns
You can read the article for yourself here, but I’ll warn you it’s pretty technical.
Let’s start with a little background.
1) Dr. Jeremy Siegel
(Note: if you’re not fully convinced the stock market is the best place to invest your money, go read this book ASAP!)
2) CAPE ratio
In the article, Dr. Siegel evaluates the Cyclically Adjusted Price-to-Earnings or CAPE ratio. The CAPE ratio is a popular method used to value the stock market and forecast future stock market returns.
You may be familiar with the more traditional and simpler valuation metric Price-to-Earnings or P/E ratio. The P/E ratio is the price of a stock per share divided by the earnings (net profits after expenses and taxes) per share.
Analysts typically use the past 12 months of earnings for the company or project 12 months of forward earnings to calculate the P/E. One of the problems with this valuation approach is that earnings tend to be pretty volatile and cyclical, so Dr. Robert Shiller decided to make a key adjustment with the CAPE ratio.
3) Dr. Robert Shiller
The CAPE ratio is also commonly known as the Shiller P/E in honor of Dr. Robert Shiller, who developed the ratio. Dr. Shiller is an Economics professor at Yale who won the Nobel Prize in 2013, largely for his development of the CAPE ratio.
In order to “smooth out” the volatility of earnings issue with P/E, Dr. Shiller took an average of the past 10 years of earnings and also made an adjustment for inflation. By doing so, the CAPE ratio would be more stable and has proven to be a better indicator of future investment returns.
What does the CAPE ratio tell us?
In the article, Dr. Siegel notes that “In January 2015, the CAPE ratio reached 25.04 – 54.9% higher than its long-term mean – forecasting a 10-year future real stock return of only 2.2%”.
(Note: real return = after inflation return. If your investment return is 10%, but inflation (the increase in the cost of goods and services we purchase every day) is 7%, then your real return is only 3%)
A 2.2% real return for the next 10 years is fairly dismal. The CAPE ratio as I’m writing this article is 27.04, which would suggest even lower real returns for the next 10 years.
However, I’m not sure what else you can invest in right now to get a 2% real return for the next 10 years either so maybe we should be content with it.
IMPORTANT TAKEAWAY #1
Dr. Siegel makes some great points as to why the CAPE ratio is too high and therefore underestimates future returns.
Dr. Siegel notes that accounting standards (GAAP) have changed significantly over the last two decades. And that these changes have caused reported earnings to be significantly lower in the last 20+ years than they have been historically.
So basically the denominator in the Shiller P/E formula has not been consistent over time.
If earnings today are less than they were in the past simply due to the accounting changes, then the Shiller P/E or CAPE ratio is overstated.
This is very good news.
After Dr. Siegel adjusts to an earnings definition (NIPA Profits) that has stayed consistent since 1928, he finds that the January 2015 CAPE ratio is only 17.28 vs. a historical 16.14 (7% higher than average).
This adjusted CAPE ratio projects a 5.25% real return going forward vs. the 2.2% projection from Shiller’s CAPE ratio.
If the stock market is going to offer a 5.25% real return for the next 10 years, then turn off CNBC, get your money fully invested, and enjoy the ride!
IMPORTANT TAKEAWAY #2
The CAPE ratio has an R2 of 35%.
Now you may not have a background in statistics so R2 may be meaningless to you. But let me give you the short takeaway – it means the CAPE ratio only explains 35% of the variation in future stock returns.
35%. The absolute best formula we have to predict future stock market returns and a formula that won it’s creator a Nobel Prize only explains 35% of future returns.
So even if Dr. Shiller’s CAPE ratio is exactly right, that leaves 65% of future returns up in the air. (And, if Dr. Siegel is right, that predictor needs some pretty serious updating for accounting changes).
This tells me emphatically that future investment returns are simply unknowable.
So what do you do with this information?
That’s a great question and get’s us to the bottom line.
If you can’t know the future, then I would suggest looking to the past as a guide. The past shows us that the stock market – owning businesses across many different industries – has been the greatest wealth-building vehicle known to man.
Since 1926, the S&P 500 has produced compounded real investment returns of 6.9%!
So don’t waste your time worrying about what you can’t know or trying to time the market based on valuation measures. Don’t listen to the talking heads on CNBC or whatever media source you listen to. Recognize that they are in the business of selling you more news NOT giving solid investment advice.
Instead, develop a plan, invest according to that plan, and let the future worry about itself.