Since Pfizer announced the success of its vaccine on November 9th most major stock markets are up 10% or more. The bull case is that Covid-19 will be tamed next year, economies will fully recover and central banks will keep rates low for a very long time. Some would add hopes for more fiscal stimulus in the US and the likelihood that the Senate will remain in Republican hands, trimming Democrats ambitions for tax rises.
But what about valuations? Arguably, valuations were high in the US even before the latest lift in stock prices. Is there any room for further gains? And what about other markets?
At Tricio we look at various measures but are especially partial to the CAPE ratio (cyclically adjusted price earnings ratio). This measure was developed by Robert Shiller, Nobel prize winner in economics (technically not a Nobel but usually treated as such) and the idea goes back to legendary investor Benjamin Graham, writing in the 1930s. It relates the current price of stocks or an index to 10 years of earnings, thus smoothing out the measure across upswings and recessions. Over the last 120 years the CAPE ratio has averaged about 17 in the US and 16 in the UK.
The US is now at 34.3 (according to Barclays’ calculations), well above year-end 2019 levels and a level last seen in 2001 when it was on the way down from its bubble highs up in the mid-40s. Today’s level is about the same as in 1929. Japan and China (at 22 and 19 respectively) also have CAPEs above year-end 2019 levels, probably because their economies have held up relatively well this year, while Europe and the UK are still well below end-2019 levels.
Low interest rates justify higher CAPE ratios
The high level in the US is sometimes justified by low interest rates but Europe, the UK and Japan have low rates too, so that can’t be the whole story. The US index also has more growth stocks than other regions which gives the explanation more weight. Low rates, especially low long-term rates mean that higher earnings 10-30 years out are worth more when discounted. The US 30-year Treasury yield was 2.2% last December and is now only 1.7%. But the 30-year yield averaged about 3% for most of the 2010-18 period so perhaps the market is still adjusting to this move.
In my view, low rates (especially low real rates) do justify somewhat higher CAPE valuations than in earlier years. (Low nominal rates might only mean that inflation is expected to be lower in future which should not make any difference to valuations.) Low real rates mean that it is OK if CAPE ratios are somewhat higher than historical averages, but the US CAPE looks extreme.
At Tricio our conclusion is that the US is expensive, the UK is cheap and Europe and Japan are fair value. Explanations for the UK lagging include the FTSE 100 preponderance of low-growth stocks in banking, energy and utilities but also the uncertainty over Brexit. I will leave China to another blog as that is a rather different story.
Implications for returns
High US CAPE implies lower long-term returns
It is important to emphasise that CAPEs don’t tell us what is likely to happen over a short period of a year or two. Momentum seems to trump valuations. There is evidence however, that CAPE valuations are useful for thinking about 5-year and 10-year returns. For example, the returns from February 2001, the last time the US CAPE was at 34 were 4.1% over 5 years and 3.9% over 10 years (including reinvested dividends). Not bad but not stellar (and much coming from dividends). In contrast, returns since February 2009, when the US CAPE fell to 12.4, are 15.1% pa to today. A comprehensive study by the Brandes Institute in 2018 confirms this tendency for high CAPE ratios to deliver low returns and vice-versa over 130 years of data.
Attacks on CAPE
There have been various attempts to argue that CAPEs are no longer a reliable indicator. For example, a study by Jeremy Siegel argued that changes in the way company profits are reported means that earnings have fallen more in recent recessions than in the past, thus tending to raise reported CAPEs in recent years.
For a refutation of this and other criticisms of CAPE see this study by Rob Arnott and collaborators at Research Affiliates. Their conclusion is that as the US equity market has matured over 100 years or more, the equilibrium level of the CAPE has trended upwards and may now be around 20 (higher than the long-run average of 17). But today’s US level is much higher than that. They agree that low interest rates support higher valuations but argue that first, this may be temporary and secondly it does also imply low returns since it suggests that the economy will not grow fast.