The sCAPEgoat

Why Valuations Get More Attention Than They Deserve

Photo: Pixabay

A few months ago I wrote a piece demonstrating why investing a large sum of money immediately (even in a more conservative portfolio) would typically be better than averaging-in over time.  Josh Brown and I even did a video where we got to discuss the nuances of implementing such a strategy.

However, despite my best efforts, I wasn’t able to convince a vocal minority of investors who had many justifications as to why investing a lump sum today would be a bad idea.  Between Trump and Brexit and the trade war and [insert your event of choice here], these investors are convinced that investing large amounts right now would be crazy.  I mean, with these headlines, how could U.S. stocks keep going up, right?

But, you already know where this logic train is headed.  It’s headed down a path that tells you all the reasons why you should sell or stay out of the market.  But, what makes this argument compelling is that the same commonly cited piece of data is used to support it—valuation.

The most relied upon valuation metric among investors is the price-to-earnings ratio (P/E) or the cyclically adjusted price-to-earnings ratio (CAPE).  These ratios are a measure of how much investors are willing to pay for $1 of corporate earnings.  A CAPE of 15 means that $15 will buy you $1 of earnings.

As you can see, a higher CAPE implies that investors are willing to pay more for the same $1 of earnings.  It might seem irrational that investors would pay more for $1 of earnings in one country over another, but taking into account differences in country risk and future growth expectations can cause a divergence in valuations.

The most recent data from Robert Shiller shows CAPE at ~30 for U.S. stocks, far above their long-term historical average of 17.  It’s this single data point that prevents more investors from pulling the trigger on investing in the markets than just about anything else.  And I understand their fear.  U.S. stocks are valued quite a bit above their long-term average and every investor knows what tends to happen when this occurs.  Higher valuations (CAPE) imply lower future expected returns.

If you look at the starting CAPE for U.S. stocks and the return they have over the next 10 years from 1940-2008, this negative relationship is clear:

With relationships this striking, how could anyone argue otherwise?  Well, there are two causes for concern.

One, there are lots of periods where higher CAPE values (~30) still provided positive annualized returns.  And with negative interest rates across much of the globe today, I don’t see how lower expected returns are a problem, assuming these returns remain positive.  Given that the main alternative to investing in stocks (i.e. bonds), yields near zero (or less) when adjusted for inflation, what other options do you have?  I’d rather have some positive return and pay a higher valuations than no return at all.

The second issue with this chart is that it groups together CAPE values and future expected returns from many different market regimes.  If you break these periods out over time, you will see that the strength of the negative relationship between starting CAPE and future returns varies over time:

If we look at the period from the mid 1970s to the mid 1990s, the relationship between starting CAPE and future 10-year returns is non-existant:

Of course this is just one period of many, but it goes to show that starting CAPE does not always predict future returns.  The relationship is strong, but not ironclad.

And even when the relationship does hold, as I alluded to before, stock returns are still usually positive.  For example, if we take the period following the DotCom bubble, all valuation levels led to a positive 10-year return:

So what are you going to do?  Are you going to continue to believe that valuations are too high at these levels?  Maybe you are right.  But, how high is high?  CAPE hit 24 back at the end of 2013 and, since then, U.S. stocks are up an inflation-adjusted 61% (including dividends).

“But Nick, stocks are overvalued now, so that 61% gain won’t last.”  Maybe.  But even if U.S. stocks were to drop 30% from today’s levels, you still would have been 12% better off had you bought back in late 2013 when CAPE first passed 24.

You can apply this same logic when deciding whether or not to buy U.S. stocks today.  But, before you shun U.S. equities, answer the following:

  • Are you willing to possibly miss out on even further gains?
  • What valuation level would U.S. stocks have to reach before you decided to invest?
  • If the CAPE on U.S. stocks remains elevated (>25) over the next decade, would you reconsider your beliefs on valuation?

If you are sitting on lots of investable cash, you should know exactly how you would answer these questions.  Because if you don’t, then what are you doing?

Data Isn’t Everything

I know the value of valuations.  I’ve previously written about their importance in investing.  And while I don’t deny the usefulness of CAPE, I also don’t revere it as the be-all and end-all of our industry.  As someone who looks through data constantly, I know the value of a good metric and a good story that accompanies it.  But, data isn’t everything.  Sometimes relationships break down.  Sometimes we can be fooled by randomness, seduced by patterns that aren’t there.

It’s this trait that makes us so good and so bad at investing at the same time.  Analyzing trends and recognizing patterns helped us to master our environment, but these same tendencies can also lead us astray.  Valuations are just one area where blindly following data can be misleading.  Because valuations are always a relative measure.

For example, is a CAPE of 20 high or low?  It isn’t either.  It’s just high or low relative to what people have paid historically.  That’s it.  If investors collectively decide that they want to pay more for the same amount of earnings going forward, then what used to be considered “high” is now normal.  As economic circumstances change, so will peoples’ willingness to pay more (or less) for stocks.

So you can either invest now, or continue to demonize high valuations as your sCAPEgoat.  Your move.  Thank you for reading!

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This is post 148. Any code I have related to this post can be found here with the same numbering:

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17 Responses

  1. Anonymous commented on Oct 29

    Hi Nick,
    With the psychological side of investing, and as a responsible individual, it pays psychologically to have some cash on the sidelines. To have some buffer room to add in the case of a pullback or recession. This psychologically buffering is a cost, but helps some people sleep at night. Akin to having the storage room stocked with tuna and dry crackers and the sort.

    Otherwise, why would Warren Buffet have $122 Billion in cash right now? Warren’s rule is not to lose money. He is willing to wait for opportunity even if it costs him gains in the short term. I have seen other blogs out there too right now who are doing the same. Buffets Ark has been built when the weather was good when he could have been on the beach and he is ~90 years old and he still cares enough about the future to build his ark.

    The other thing is Buffet would suggest to others to just invest in the S&P, but when it comes to his own money, he is holding more cash. Also, Apple holds a lot of cash too, likely other businesses do too. For those who have lived through 2008, it’s more of a survival mechanism, albeit a very expensive one, where without a level of psychological safety and maneuverability, holding through recessions without the ability to act can be relentlessly taxing on the soul.

  2. Anonymous commented on Oct 29

    Scary article because the author makes an argument using data and then says data isn’t everything…

    • Nick Maggiulli commented on Oct 29

      It is the week of Halloween after all…

  3. Anonymous commented on Oct 29

    Let me ask a related question: At what valuation (or other metric) would you NOT invest?

  4. Anonymous commented on Oct 29

    An emergency fund, right? Something we should all aim to have is to build up 3-6mths earnings.

  5. Anonymous commented on Oct 29

    There are three factors that I believe have a significant impact on valuations
    1. Revenue and Expense recognition rules have changed favorably over time
    2. Corporate Tax rates in the US have declined every decade for 60 years or so
    3. Interest rates are very low, making equities more valuable relative to bonds.

    2 of the 3 trends above are likely relatively permanent, so I would not be surprised to see a ‘permanently higher plateau’ of equity valuations (If using that phrase doesn’t jinx me I don’t know what will!) I don’t see any reason valuations have to decline soon. In the long run, I’m sure they will vary.

    At the same time, I’m very cognizant that at 3 to 3.5% for 5 yr Trsy yields, the value proposition for stocks is less appealing… at that point valuations will very likely decline. Preparedness makes it all easier to stay the course.

  6. Anonymous commented on Oct 29

    You ask where else to invest? Countries with lower CAPE, i.e., emerging markets.

  7. Anonymous commented on Oct 29

    Warren isn’t buying anything because he cant find a good deal that he could deploy a significant amount of his capital at without hugely affecting the market.

    Just using 10% of that 122 billion means he could buy any business valued at $12 billion or less. That is not what he wants to do.

    If he were to invest normally( i.e 10% of a company) the investment amount would not move the needle in terms of performance for his company. It would not be worth his time.

  8. Anonymous commented on Oct 30

    It is relative, exactly. This is why I usually discard the 100+ year average CAPE. Human biases may not have changed much over this time period but culture, markets, capital, and tools definitely have. The most recent 30 year average (25.81) and 50 year average (20.33) are significantly higher than the all-time average (16.66). If you wait until 16.66 to buy in, you might be waiting on the sidelines for a few decades or more while dividends and buybacks get distributed to other shareholders.


  9. Anonymous commented on Oct 30

    A compromise might be investing one-third of the available cash right away, one-third DCA and sitting on the last third waiting for the opportunity to pounce.

  10. Anonymous commented on Oct 30

    Great, thought provoking article. Thanks for writing. As a lowly wage worker who know there is a lot I don’t know, I will continue to just invest every paycheck in my 401K month in month out, and let the chips fall where they may, CAPE wherever it is. I do top up at the end of the year with excess savings but I don’t know my extra amount until the year is done. They I guess I just invest my lump sum at all once. If we were crashing, like in 08/09 I would hold my cash until things settled down, but even then, you never really know when you hit bottom. At some point I would be back in and continue my month to month buying. Thanks again. I always love your articles.

  11. Anonymous commented on Oct 30

    It might be useful to plot along the return line for various periods and capes, the return one might have earned by an alternative investment in either corporate or gov. bonds ?

  12. Anonymous commented on Oct 30

    A good portion of the total returns are from dividends, correct? Last I saw the dividend yield on the S&P was 1.8% – 1.9%? There are banks that offer 1 year CD’s at 2.2%. Why would I want a lower divendend yield and more risk as opposed to CD’s?

    • Nick Maggiulli commented on Oct 31

      Inflation. Take out 2% and now your CD is earning next to nothing. If you need to safeguard this, that’s fine, but if you need growth, it ain’t happening from a CD.

  13. Anonymous commented on Oct 31

    How has growth worked out for Japanese investors since the 90’s?

  14. Anonymous commented on Nov 04

    •Are you willing to possibly miss out on even further gains?
    yes, from US stocks. But the investable universe is not comprised of US stocks only. I’m willing to invest in other markets with lower CAPE

    •What valuation level would U.S. stocks have to reach before you decided to invest?
    to that I shall ask you, “At what valuation would you NOT invest?”

  15. Anonymous commented on Nov 06

    Larry Conors has made the observation that the VIX is a dynamic indicator and we would be better served by using it as such; getting into the market when the VIX is x% above its 10 period SMA and getting out when x% below. Could a study by performed on the long term results of such a strategy using the the CAPE?

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