You might have missed, with all of the political theatre and pundits chattering about the impending U.S. default last month, that Professor Robert Shiller shared the Nobel Prize for Economics this year. With the stock market hitting new highs on the resolution of the debt-ceiling debacle and the nomination of Janet Yellen as Federal Reserve Board Chairwoman, we thought it an apt time to revisit the Shiller-popularized Cyclically Adjusted Price Earnings ratio (CAPE). We have modified his original work; we use a 10-year real average S&P 500 earnings compared to subsequent 10-year S&P 500 total returns. He focused on 20 year returns but admitted that 10 years works pretty well, too.
To summarize, Professor Shiller’s conclusion was stock prices, on the whole, are much more volatile than the underlying dividends or earnings would suggest (i.e., something else, likely emotion, is playing a large role in observed volatility). With that insight, Shiller went on to suggest that investors could improve their long-term results by committing funds to the stock market when the CAPE [also known as P/E(10-year)] ratio is low and dialing down their risk level when the ratio is high. The first chart to the left, from his book Irrational Exuberance, displays the results of his research with the horizontal axis plotting the 10-year inflation adjusted P/E (CAPE) and the vertical axis plotting the subsequent 20-year annualized stock market return. This is a simple, if not axiomatic, concept for any investor: buy low, sell high. As history demonstrates, however, it is a difficult concept in practice when emotions (greed and fear) enter in to the equation.
So, what should investors expect given today’s earnings and stock prices? We have updated and adjusted, as indicated above, his research with data through September 30, 2013 (note, too, we have removed a few data points from the Great Depression which we believe skew the plotted data but don’t change the overall conclusion). The next chart to the left displays that research with a logarithmic trend line and intersecting lines indicating where we are today (Adj CAPE of about 21). Our best guess is investors should temper their expectations, after nearly five years of a recovering market from the Great Recession, to a return range of 6-7% over the long run from today’s market valuation. Also note, the deviations from the trend line at higher market valuations (lower down the curve in the second chart above) appear to be larger to the negative side.