Link to: Forecast 2014: The CAPEs of Hope
Last week's letter focused on my 2014 outlook for the US stock market and highlighted an important, but controversial, measure for long-term valuations: Robert Shiller's cyclically adjusted price-to-earnings ratio (CAPE). Unlike the more common trailing 12-month P/E ratio, Shiller's CAPE smooths out the earnings series and helps us avoid what could be false signals by dividing the market's current price by the average inflation-adjusted earnings of the past 10 years. Historically, this range has peaked and given way to major market declines at around 29x on average (26x excluding the dot-com bubble), and it has usually bottomed in the mid-single digits. Except for relatively brief windows during the late 1920s, the late 1990s, and the mid-2000s, Shiller's CAPE ratio has never been as expensive as it is today (see chart below).
As you can see, the S&P 500's high and rising CAPE ratio signals that US stocks are sailing into a well-proven danger zone. Also note that if we get a repeat of the stock market prior to 2007, the market can stay at this elevated range long enough to make investors complacent.
Not only does today's CAPE of 25.4x suggest a seriously overvalued market, but the rapid multiple expansion of the last few years coupled with sluggish earnings growth suggests that this market is also seriously overbought, as I pointed out last week and as we are seeing play out this week. Today's CAPE is just slightly less expensive than the 27x level seen at the October 2007 market peak and modestly below the level seen before the stock market crash in 1929. Although we are nowhere near the all-time "stupid" valuation peak of 43x in March 2000, a powerful narrative drove the markets to clearly unsustainable levels 15 years ago and a powerful narrative is driving markets today. Then it was the myth of dotcom and new tech, and now it is the tale of QE and the Fed.
Unfortunately, the outlook for US stocks only looks more daunting when we examine CAPE ratios for foreign equity markets. Mebane Faber, chief investment officer of Cambria Investments and author of The Ivy Portfolio (2009) and Shareholder Yield (2013), regularly posts international CAPE updates to his research blog, The Idea Farm (www.theideafarm.com). Meb was kind enough to let me reprint his year-end 2013 update here.
A quick look reveals that the S&P 500 is the second most expensive stock market in the world today on both an absolute and a relative basis, second only to that of tiny Sri Lanka.
Expanding on recent valuations, Meb's work highlights that the relationship between CAPE valuation and subsequent returns is still very much intact. This next table compares the relative returns of the most expensive and cheapest markets. Study it carefully.
On average, the cheapest 10 markets as 2013 opened returned over 21% last year, while the most expensive 10 markets lost more than 5%. This is just one year, but we would expect to see the same basic relationship over the course of the next decade, if history is a reliable guide. I want to draw your attention to a fascinating observation: look at the outliers.
Russian stocks lost almost 1% in 2013, despite showing the fourth lowest CAPE at the beginning of the year. That's not a huge surprise. Valuations tell us a lot about long-term potential returns but not much about short-term timing. Momentum works until it doesn't.
US stocks tell quite a different story. They returned over 30% last year, despite starting 2013 with the sixth highest CAPE valuation. Rather than reversing course in the face of sluggish earnings growth, CAPE multiples expanded from 21.1x to 25.4x. By comparison, every market that started 2013 with more expensive CAPEs than the US's saw notable reversals of fortune, especially the top three: Peru's CAPE fell from 33.7x to 19.7x; Columbia's fell from 33.5x to 23.9x; and Indonesia's fell from 24.7x to 20.1x.
The impressive thing about US stocks is not simply that positive sentiment and Fed liquidity continued to drive valuations higher, but that the market rallied as much as it did with very modest earnings in the face of historically dangerous valuations. I have said it before, and I will say it again: Sentiment, rather than fundamentals, is driving the US stock market, and sentiment can quickly reverse.
Since we have no idea when the inevitable correction will come, we must expect it at any time. Shiller's CAPE can keep rising longer than any of us expect in the United States, but no one should be surprised if it corrects next week, next month, or next year.