I often tell my clients that the different stock market valuation methods can help us estimate future stock market returns. Naturally, this gets them pretty excited. I mean, knowing the future is pretty helpful when it comes to investing, right?
Well, not so fast.
Stock market valuations are more like a hazy compass than a GPS system. Valuations can usually point you in the general right direction, but they can’t tell you what road to take or how long the journey will last. In essence, valuations are very useful for long-term planning, not so much for specific short-term moves.
As I explain, when stocks are expensive relative to history, it generally means lower long-term returns – but, importantly, not always. Sometimes expensive stocks just stay expensive or even get more expensive. And sometimes cheap stocks get even cheaper, at least for a little while.
Basically, you have a range of returns at each level of valuation, but the subsequent returns definitely show that on average cheap stocks earn higher returns over time compared to expensive stocks. You just can’t rely on it for short-term (less than ten years) planning.
Frankly, it’s a difficult concept to understand in the abstract. Thankfully, a smart German researcher, Norbert Keimling of StarCapital, has created the perfect graph to illustrate what I mean.
The chart shows the future 10-15 year annual real returns (i.e. above inflation) of stocks markets in the United States and other developed countries from 1881 to 2015 at various starting valuations. In this case, Keimling is using the CAPE to value stocks.
So what’s the CAPE? The “cyclically adjusted price/earnings” (CAPE) ratio, is a valuation method designed by nobel-prize winning Prof. Robert Shiller. Shiller takes the current market price of a stock market such as the S&P 500-stock index for the United States, divides by the total earnings of the companies in the index averaged over the past 10 years, adjusting all the numbers to account for inflation.
By using an average of 10 years of earnings, the CAPE takes into account the ups and downs of the business cycle. After all, we don’t want to value a company (or stock market) based on one or two unusually good or bad years.
The chart shows the current CAPE ratio for various countries. For instance, the United States is at a CAPE of ~27, while the Russian stock market is on the other end of the spectrum at around a CAPE of 6.
The chart clearly shows three important things:
- Stock markets with lower CAPEs tend to earn higher returns over the next decade.
- The range of returns is high enough that you can’t rely on the CAPE for market timing.
- The United States stock market is not poised for high returns; indeed, we’d be happy with average returns.
So should we put all of our money in Russian stocks? Should we ditch U.S. stocks? The answer to both questions is, No. U.S. stocks have had a very high CAPE relative to other countries for the past five years. What happened over those five years? U.S. stock returns crushed international stocks.
The CAPE isn’t for market timing!
However, you’d be crazy to assume that U.S. stocks will earn their historic real return over the next decade given the U.S. market’s current CAPE valuation. Generally, that CAPE valuation led to annual real returns between 2.0% and 6.0%, so let’s just use 4.0% for our best guess. That compares to ~6.5% historically for U.S. stocks. (But, remember, that CAPE level also has seen 10-15 year annual real returns as low as -2% and as high as 11%.)
Our hazy compass is pointing to low returns for U.S. stocks over the next decade with non-U.S. developed international stocks producing reasonable returns relative to history (~6.0% annual real return) and emerging markets earning closer to 7.0% annual real returns.
Given that bonds aren’t expected to earn much, if anything, over inflation for the next decade, Americans investors that hold only U.S. stocks and bonds should expect very low returns relative to history. For example, an investor that has a portfolio of 60% U.S. stocks and 40% bonds could expect an annual real return of ~2.5% a year. If we add in 2.5% inflation, the investor would earn ~5.0% nominal.
Historically, Americans have earned ~4.5% to 5.0% a year above inflation and 7.5% to 8.0% nominal for that same portfolio. If Americans continue to use those historical numbers in their retirement plan, they are likely in for a nasty surprise.
Americans need to plan for lower returns. They may be able to help mitigate those lower returns by diversify their stock allocation into developed international and emerging market stocks. But even if international stocks help their portfolios, Americans are still looking at lower returns relative to history.
Now is the time to adjust your plans.