More Than Zero

In my last blog entry I commented about the worrisome consequences of a low return investment environment. This immediately begs the question, exactly why do we think that investment returns will be low?

There are two popular schools of thought about investment returns. The first is trend-following.   Behavioral economics suggests that human beings are hard-wired to be trend followers, especially when under stress.  (Bear markets and high volatility are both very stressful.)  Our trend-following brains assume that whatever happened in the recent past will continue in the future. Given the dreadful markets of the last decade, many individual investors expect the next ten years will be more of the same: high market volatility and lousy returns.  Hence they are out of the markets.

The counter expectation is trend-reversing, an essentially cyclical view.  Since the last ten years have been arguably the worst in the modern history of the US stock market, then surely the next ten will be well above average; just as the extended sideways market from 1967 to 1982 was followed by almost two decades of 18%-plus returns, surely the poor returns since 2000 will be followed by exciting returns going forward.  We hear this a lot from other advisors, who want to reassure their clients that better times are certainly ahead.

We think neither of these seat-of-the-pants methodologies is persuasive. Instead, we rely upon a price rule, and specifically on the model created by Yale economist Robert Shiller.  Shiller is the author of the 2000 bestseller Irrational Exuberance, which correctly predicted the collapse of the stock market bubble. He is also the co-creator of the Case-Shiller housing price index, which documented the recent collapse in house prices…which Shiller also predicted back in 2005.  (Smart guy.)

Shiller’s stock market methodology is generally referred to as the Shiller CAPE, which means cyclically adjusted price-earnings ratio.   Briefly, it compares the current price of the S&P 500 Stock Index to the trailing earnings over ten years.  (Using a ten-year trailing average largely eliminates the extreme short-term volatility of corporate earnings.)  Shiller’s methodology can be summed up in one phrase: future returns are a function of current prices. Consider the graph below:

Shiller CAPE graphYou can see that the market low of 1982, with the Shiller CAPE below 8, was followed by a generation-long bull market, which ended in 1999 with the trailing price-earnings ratio well above 40 – by a considerable margin the highest valuation in history.  From that high price point, subsequent returns were awful.  More recently, during the Great Panic that followed the financial crisis of late 2008, stocks reached below-average prices, bottoming in March of 2009 at 13 times earnings.  An explosive rally followed, with the S&P 500 up more than 95% in less than two years.

Several conclusions can be reached by examining the Shiller CAPE chart. First, prices are very volatile in both the short and long run.  Second, market cycles can be long, but in the end they are not unconstrained by reality.   Good news or bad news, panic or euphoria, boom or bust, war or peace, market values always revert to the mean… eventually.

Note that the current Shiller CAPE is roughly 23, on the high side of fair value, but not insane.  So what does that suggest about future returns?  Consider the chart below:

Shiller CAPE and future returnsThis scatterplot makes clear that the current price of the market is systematically related to its subsequent ten-year performance.

So to cut to the chase, what does the current Shiller CAPE value of 23 suggest about returns going forward? If we simply draw a vertical line on the CAPE vs. return chart at 23 times earnings, it intersects the best-fit trendline (the red curve above) at about 6.5%.  We discount this by 1.5%, to reflect our concerns about structural factors (massive debt overhang, unfunded entitlements, stagnant middle-class incomes), to arrive at a baseline market return expectation of 5%.

This is not a precise prediction, but rather a rational connection between current price and long-term return potential.  Note that the range of possible outcomes at any given price point is significant.  Still, we believe this represents a more robust methodology for thinking about market returns than the usual Wall Street nonsense of predicting the next quarter’s economic growth or forecasting the future earnings of individual companies.

One massive caveat — because the CAPE is a long-term methodology, it tells us absolutely nothing about what the market will do next week, what the result of the next Euro-summit will be, whether or not Congress will raise the debt ceiling or which party will control the White House after 2012.  Any of these factors could have a major effect on the market today, this week, even for years to come.  Unfortunately, those short-term market drivers are tough to predict.

Of course, if you could predict the market reliably on a day-by-day basis, you would not need the highly imperfect long-term measure of the Shiller CAPE.  For that matter, you wouldn’t need an investment advisor.   Good luck with that.

For the rest of us, who lack a precise short-term crystal ball, here is why we believe the CAPE number really, really matters.  A projected 5% long-term return on the stock market certainly isn’t exciting, and it won’t make us rich in a hurry.  But what are the alternatives?  If we compare a prospective return on the stock market of 5% to the less than 2% coupon return on a ten-year Treasury note, or the 0.3% return on money market funds, the stock market starts looking like the only game in town.

But what if a 5% return on the stock market, or a 3% return on a balanced portfolio including bonds and cash, isn’t high enough to realize your economic goals? Surely there must be something else out there that will earn higher returns?

Our answer is, not necessarily or even probably. And I’ll talk about that more in the next set of posts.


2 thoughts on “More Than Zero

  1. If people are “overpaying” for stock, overpaying compared to what? It would seem whatever asset they have stopped buying in order to overpay for stock should be yielding better than its normal returns. Where does the money go when it is not going in to stock, when the P/E is low?


    • That is always one of the big questions with investments, “compared to what?”

      Right now I’d argue that bond prices are insane, and cash obviously is yielding nothing. (But unlike bonds, won’t go down in nominal dollar terms if yields rise.) The stock market’s PE is on the high side of fair value, we think, but still in a range where long-term returns should be positive. (After we put up this post, I ran across an interview with Shiller, who said essentially the same thing.)

      The question is whether there is something somewhere that has a stronger prospective economic return. We are looking at non-public real estate, but it would have to be extremely compelling for us to be willing to give up the intrinsic transparency of publicly-traded securities.



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