Stocks Overpriced? Take a Deeper Look

Tuesday, August 21, 2018 |

A concern of some clients, which is reinforced by some in the financial media, is the valuation of stocks using the Cyclically Adjusted Price to Earnings ratio (CAPE) and their subsequent forward returns that indicate stocks are in general overpriced. I aim to lessen those concerns in this post:

  1. The concern is not without merit, CAPE is currently at it’s highest level outside of 1929 and 2000. Its 32.29 rating is nearly double the long-term average of 16.89 (source: Bob Shiller).
  2. Long-term forecasters are projecting 10 years forward returns reverting to this long-term valuation average come in at about 5% annualized (source: Research Affiliates). However, those forecasts neglect to take into consideration the following…
  3. When 2008 and 2009 earnings are removed (and those are rolling off in the next 12 months or so) the CAPE metric is closer to 28.
  4. Valuations have increased over time from 1871 and thus mean reversion is likely not the best choice for forecasting returns (see Chart 1, see dotted line) in our opinion.
  5. When looking at the r-squared for 10 year forward returns and CAPE, which is to say the 10 year forward returns explained by movements in CAPE, the highest r-squared is found when looking at the CAPE level relative to the 60-year rolling average (0.47) rather than simply the average (0.31). It’s also higher at the 40-year rolling average (0.34). Thus, the rolling average tends to be a better indicator of forward returns than just using the average (source: Capital Advisors, Ltd.).
  6. Also, it should be noted the r-squared for both the rolling returns average and the average are relatively insignificant over 1, 3, and 5-year periods (source: Capital Advisors, Ltd.). Thus, we believe CAPE tells you little about what stocks will do over the intermediate-term.
  7. When we use the 40-year rolling average (while lower r-squared, more data points than the 60-year rolling average) our forecast comes in at around 4% real annualized + 2% or so inflation = 6% (see Chart 2).
  8. Further, you can see from the forecast (2nd chart below) there is a lot of deviation (the same is true for the aforementioned Research Affiliates forcast). As such, we tend to think it’s better to use a range.
  9. Thus, if we look at similar valuation ranges (see Table 3 average and standard deviation), stocks are likely to have a return somewhere between 3% and 9% (1 standard deviation away from the forecast) with a high probability (90%+) of being positive over the next 10 years. These returns are probably going to be below the long-term average of around 9%, but 6% isn’t awful our opinion.
  10. To conclude, traditional long-term valuation metrics appear stretched; however, when taking a deeper dive, the data seems to indicate that stocks are positioned to do well (likely not great) in contrast to what is being forecasted by more traditional long-term valuation metrics.
 

(source: Bob Shiller and Capital Advisors, Ltd.)

 

(source: Bob Shiller and Capital Advisors, Ltd.)

(source: Bob Shiller and Capital Advisors, Ltd.)

 


The CAPE Ratio or the Cyclically Adjusted Price Earnings Ratio, also known as the P/E 10 Ratio or the Shiller Ratio, was developed by Dr. Robert Shiller an Economist from Yale University. Shiller analyzed the S&P 500 Index from 1871 to the current day to determine if a ratio similar in nature to the common P/E ratio but with the added twist of 10 years of Earnings per Share (EPS) data would be effective and more accurate in determining if the market as a whole was overvalued or undervalued. More information can be found at www.caperatio.com.

S&P 500 Index is an index of 500 of the largest exchange-traded stocks in the US from a broad range of industries whose collective performance mirrors the overall stock market.

Price earnings ratio is based on average inflation-adjusted earnings from the previous 10 years, known as the Cyclically Adjusted PE Ratio (CAPE Ratio), Shiller PE Ratio, or PE 10.

Real Return is the annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation or other external effects.

Past performance is no guarantee of future results. The above hypothetical example is for illustrative purposes only and does not attempt to predict actual results of any particular investment.

R-squared is a statistical measure that represents the proportion of the variance for a dependent variable that's explained by an independent variable. In investing, R-squared is generally considered the percentage of a fund or security's movements that can be explained by movements in a benchmark index.

The standard deviation (σ) is a statistic that measures the dispersion of a dataset relative to its mean and is calculated as the square root of the variance. It is calculated as the square root of variance by determining the variation between each data point relative to the mean. If the data points are further from the mean, there is higher deviation within the data set; thus, the more spread out the data, the higher the standard deviation.

Sharpe Ratio the average return earned in excess of the risk-free rate per unit of volatility or total risk.

% Positive is the rolling monthly periods that had positive rates of return over the time period.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts or Lincoln Investment.


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