A few weeks ago, Robert Shiller, the Yale professor whose stock market research won him a Nobel prize, released a new long term historical gauge of stock prices to try and understand current market valuations and where they may be headed. The new measurement, which he calls excess CAPE yield, builds on his freely available US stock market data which is updated monthly.

Shiller’s contribution in the late 1990’s was to point out that the Cyclically Adjusted Price per Earnings ratio or CAPE was at an all time high at that point going back to the 1920’s and this meant that some time in the future, the market was due for a massive correction. The CAPE is adjusted for inflation so looks at the real price versus the real earnings of the S&P 500 averaged over a 10 year period.

This prediction came true when the dot com bubble popped and the S&P 500 fell as much as 40% over a 3 year period from 2000 to 2003. This probably contributed to Shiller’s fame and maybe even to his recognition which led to his Nobel prize. However, when anyone is proven to be right on a big call, many market participants assume they will be right forever with everything. The ongoing day to day reality is murkier than a simple call of the top of a historically expensive market.

The Criticism

After the dot com bubble burst, many predicted that the US was in for a long term decline in stocks. The CAPE levels were still showing high valuations, so many adherents to CAPE as a long term predictor of returns thought returns would be weak for many years. In reality, valuations increased again amid kept increasing for another 4-5 years until the financial crisis. After the recovery of the pandemic, we now find ourselves at yet a new historical CAPE valuation which can be seen in blue below.

However, there were a number of criticisms levied at looking at valuations simply by the CAPE measure, mainly:

• It doesn’t take into account real interest rates. One valuation of the stock market is that it is future earnings discounted by the risk free rate, usually some form of US treasury securities. Real rates offered competitive returns compared to stocks in former times and this contributed to cheaper valuations for stocks then compared to now.
• Another is demographics. As a larger proportion of people approach retirement age, they may be forced to save and become market participants, in both stocks and bonds, to try and set aside a nest egg. This can push of valuations for long periods of time, even decades, as the demographic Trent pushes its way through long term market cycles.
• The other is structural changes in the macroeconomic environment as well as in public policy. Financial markets are more open than ever. Not just people in the US, but people all over the world are able to invest in equities and especially US equities. In addition, government policy has created a tax deferred incentive to invest in the stock market through retirement accounts. Social security doesn’t cut it in retirement since people are living longer than when social security was invented so people need to supplement their income with other savings, this policy, along with demographics points towards a structural shift which could elevate the CAPE figure permanently.
• Finally, volatility has decreased in equity markets from prior decades. This has roots linked to the previous factor but it’s important to know that this affects valuation levels. Less volatile assets tend to be valued more highly because investors will be willing to pay for the added stability.

The macroeconomic background is a key factor which has changed when looking 100 years or more back into past valuations. In the 1930’s or 50’s you couldn’t invest in places like mainland China, Thailand or Taiwan. Now these places are big markets for overseas investors. In addition to increasing the chance for returns, as long as the correlation is less than 1 to 1 with the US equity market, it decreases overall volatility for an investor in all of these markets. This is the fundamental argument for diversification, that it decreases volatility while still offering competitive returns. On the flip side of this, investors which were freed from the yoke of 1930’s and 1950’s planned economies are now free to invest in the US. This created a whole new market for US companies to find not just customers but ownership. Individuals and institutions in countries from Africa, to Russia to across Asia are free to invest in the US market and they have. A look at the investors in the US market since 1965 by the Tax Policy Center shows that stock market ownership has shifted massively towards both foreign and tax deferred ownership from simple taxable accounts more likely to be held by individuals.

This is the problem with blindly tying views to historical performance. This was the same thing very smart analysts and industry researchers did prior to the housing collapse and financial crisis of 2008-2009. I briefly worked in mortgage securities at the time. As a recent math graduate, I was curious to dive into the model that my company was using to predict default rates on thousands of mortgage securities. I was surprised to find that the default rates were all predicated on historical data. I asked why we had not used a probability mode as opposed to historical data to mode home prices and was immediately met with derision. I was told home prices would never fall because they had never fallen in the US up to that time and was also told that if I valued my job I would keep my mouth shut about such things. We all know what happened next, home prices did fall in the US for the first time overall and in some markets severely. Basing the data on historical figures did provide comfort and gave investors and issuers what they wanted in the short run, but assisted in hurting us all in the long run.

So it may be with trying to argue how stocks should be valued based on 140 years of data. There have been massive demographic, macroeconomic, public policy and industrial shifts in the past 30-40 years, let alone the past 100 years or more. We can’t expect the future to blindly adhere to our heuristics of the past.

The demographic factor is also an important one, some of which I touched on in my last post. Not only does a higher retirement aged population potentially increase the number of people holding stocks, it also increases the number of people holding bonds which creates more demand for interest bearing assets and raising aggregate demand. Bond prices and interest rates move in opposite directions which then decreases interest rates. This is consistent with the idea that the Fed does not control long term interest rates, but it’s rather supply and demand that does so in the medium and long term. Demographic factors could help explain one reason real interest rates have dropped so much in the past 40 years.

If this increase in aggregate retired people also occurs with a sharp decrease in the working age population, we then would see increasing savings chasing fewer domestic opportunities. This could increase the demand for investment opportunities, further raising the prices for new investments and subsequently lower their interest rates (and rates of return). This would in turn lead to the danger of this deflationary factor overwhelming any attempts by the central bank to stimulate the economy and lead to deflation. Deflation would then suck demand from stocks rather than push them up because it all the sudden makes bonds, even those with nominally negative interest rates, more attractive compared to stocks. This is what happened in Japan as there was a severe demographic decline in the working age population.

The US, although seeming to flatten out in the past 5 years, can counteract this with immigration, something Japan did not want and has still strictly controlled.

Back to CAPE

I could create a whole series of posts dedicated to these issues but want to return to the point of this which is how to look at the long term valuation of the market.

Shiller heard these criticisms and showing his ingentuity, came up with a new valuation that partially takes some of these into account and explicitly takes into account long term interest rates. That figure is the excess CAPE yield. If you understand the CAPE, it just extrapolates from that. It flips the numerator and denominator of the CAPE to get the 10 year average earnings yield of the stock market. For example an earnings yield of 5% would mean that the P/E of the market is 20 (1/0.05). He then subtracted from this figure the yield on the 10 year treasury note with the logic that this is the rate of return to risk free bonds that competes with stocks. The result is the excess CAPE yield which is plotted below.

This would show that based on interest rates, the picture isn’t as clear as the old CAPE ratio in terms of the market being overpriced. In fact, it seems to be pretty reasonably priced even compared to history.

We can look at the years noted in the past as when the excess CAPE yield peaked signaling a long term buying opportunity for stocks.

The other thing worth noting is that the excess CAPE yield can trend downwards for long periods (meaning lower long term returns in stocks) but can do so for long periods of time. If you looked at this figure or CAPE alone going back 30 years, you may have concluded that markets were overvalued in the 90’s and missed the entire bull market rally of that decade. It’s the trend of the line downward that matters it would seem. If the excess CAPE yield has been trending downward for some time it could then signal overvaluation, but again, no one knows when that trend will reverse. In the 2000’s the excess CAPE yield even went negative for a period of time.

Outcome and Conclusions

This all points to my advice which has been tied into many of my previous posts: that diversification is the key to surviving all markets. Do we know when the tech rally will stop? No. Will inflation pick up this year or will we have low inflation or deflation? No one knows for sure. Those that tell you they know are lying for a dollar. The key is to be diversified across asset classes to be prepared for any type of market. The rich are often coached by their financial advisors in this and their assets are usually set up as such so when the bad times come, they don’t need to be on the defensive.

Shiller even points out in his research that based on this excess CAPE yield, overseas markets are attractive. The U.K. is currently yielding 10%. Europe and Japan are yielding 5%, above the 3.8% offered in the US. Then again, there is no FAANG in those countries which have carried most of the returns like they have in the US. The solution is to do both: invest in the cheap markets and ride the wave of the current US market. When the inevitable correction in the US comes, you will likely have stronger markets overseas along with a likely weaker dollar to buoy your return. The same boring advice doesn’t get old, but many still aren’t following it.

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