Shiller’s Ratio Flunks at Predicting Stock Performance
My weekend reading included a number of articles, sometimes within the same publication, arguing either that stocks were primed for a sharp decline, or were likely to continue advancing. We remain fairly positive on the outlook for equities and quite bearish on bonds.
Much of the negative outlook for stocks is driven by use of Robert Shiller’s Cyclically Adjusted Price Earnings ratio to judge whether shares are cheap or expensive. The S&P 500 Index currently trades at a CAPE above 30, which has been exceeded only in 1929 and in 2000, highly inauspicious times.
The bear case is built on the foundation that stocks are exceptionally expensive, so they must revert at some point to historical valuations. This would be a more compelling argument if the CAPE were a respectable indicator of future stock performance. In fact, its history falls somewhere between dismal and atrocious. The only time the CAPE suggested stocks have not been overvalued in the last 25 years was in 2009, when it implied that stocks were fairly valued. Stocks have tripled since then.
Any measure that works so badly over 25 years, which is roughly half a single person’s entire investment lifetime (assuming a person invests between 25 and 75), cannot reasonably be used to guide decisions. Moreover, the CAPE is likely to decline considerably over the next few years, as the depths of the 2008 recession drop out of the 10-year calculation, which reveals its weakness. It is inherently backward-looking, notably very far back, instead of forward-looking.
A recent study by Guggenheim Partners suggested that stocks might return just 0.9 percent over the next 10 years, a very weak performance even compared to 10-year Treasuries, which if held to maturity would return around 2.30 percent, more than double the projected equity return. Such longer-term projections require significant assumptions and it is a useful exercise to go through the process, since it can provide a sense of the return an investor might reasonably expect.
Corporate profits are driven by economic growth, which has clearly slowed. Inflation-adjusted growth has been running at around 2 percent for the past few years in an economic recovery off a deep recession. A forward 10-year period would also surely include a recession, so any actual 10-year average would be somewhat lower. With labor force growth over the next 10 years projected to be between 0.5 percent and 1 percent and productivity broadly between 0.5 percent and 1.5 percent, I will conservatively estimate potential growth around 1.6 percent. (Note, I’m providing precise detail on how I’m constructing this estimate of future equity returns, so readers can readily insert their own values to stress-test my results.)
We must then scale up real growth for inflation to estimate something closer to nominal sales. The Federal Reserve’s target is 2 percent inflation, though it has been below this level for the past five years. Longer-term, they have mostly been well above that level. Since it rarely pays to bet against the Fed, I’ll use 2 percent as my longer-term inflation projection. That brings our nominal sales projection to 3.6 percent.
Now, we must scale up our projections to reflect leverage in the corporate sector. The more leverage, the faster the growth in profits. According to Factset, revenue growth for 2017 is estimated at 5.7 percent and earnings growth at 9.6 percent, so profits are actually expected to grow 1.68 times faster. For the first quarter of 2018 the projected ratio is 1.70; it is 1.75 for the second quarter. Again, let’s be somewhat conservative and use a multiple of 1.6 times, which would imply profit growth of 5.76 percent annually.
According to Factset, 2017 earnings are projected to be $131.37. If this year’s earnings grow by 5.76 percent annually, in 10 years S&P 500 earnings would be $229.99. I’ll go with $230 for calendar year 2027.
Next, we need to apply a price-earnings multiple to these future earnings. The market’s forward earnings multiple is 17.7 according to Factset, but some would argue the market is expensive. Over the past 50 years, the market multiple has averaged around 16 times earnings. In a previous article, I suggested this average was extremely deceptive, since the appropriate multiple for the market depends critically on prevailing interest rates.
Going back 50 years averages both high inflation/high interest rate years, like the 1970s when single-digit multiples were common, and years in the 1950 and 1960s and 2010s, when inflation and interest rates were much lower and higher multiples were appropriate. At prevailing interest rates, a high multiple should be used, which also fits our assumptions of 2 percent inflation over the next 10 years. Nonetheless, I’ll use a multiple of 15, which implies that market pricing of that earnings growth will be significantly less favorable than today. What’s the result?
A 15 multiple on $230 in earnings for 2027 implies the S&P will be at 3,450, for an average annual return of 3.2 percent, ignoring dividends. If we add in a dividend yield of 1.9 percent (and assume zero growth in those dividends over 10 years), the market will return 5.1 percent. This is more than five times the return provided in the Guggenheim estimate and more than twice the return available on a 10-year Treasury note held to maturity. (In fact, if we are using forward earnings, one more year must be added to estimate 2028 earnings to establish a forward multiple for 2027. This implies $243.25 in earnings for 2028, and an S&P value of 3,649 in 2027 and an annual rate of return of 3.7 percent plus 1.9 percent for dividends or a total return of 5.6 percent annually, again ignoring dividend growth for 10 years.)
Long-term, equities are still the place to invest, assuming investors can handle the greater volatility in stocks compared with bonds.
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