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Many fund managers, analysts, economists and private investors pay great attention to what the 10-year cyclically adjusted price earning ratio is telling us about the level of returns we can expect from shares over the next ten years.
Note that while thinkers in this field tend to emphasize evidence showing a relationship between exceptional high CAPEs and average annual real share returns for the decade following, they are much more cautious about stating when a stock market downturn is about to happen – they have been caught out too many times in the past, as we will see with Shiller’s 1997 writing (published in 1998) in this Newsletter.
Observation: The US CAPE has been above its 146-year average of 16.7 every month since 1991, except for 10 months in 2008-09. It has been above a value of 20 since 2011. This would signal a low return on equities for the following ten years if the model is obeyed at all times. But since 2011 the market (S&P500) has risen by over 80%. On the other hand, the fact that the market has risen so much stretches the elastic further – CAPE is now at a very extreme level.
The 1988 paper
In their first paper Campbell and Shiller investigated the relationship between the 10-year CAPE and the future return on shares. They insist on using ten years’ of earnings because “yearly earnings are quite noisy as measures of fundamental value; they could even be negative while fundamental value cannot be negative”. (Campbell J Y and R J Shiller (1988) Stock Prices, Earnings, and Expected Dividends. Journal of Finance, 43, 3.)
In this statistically dense paper, examining the S&P Composite index (forerunner of the S&P 500) data 1871 to 1986, they concluded that the ten-year earnings price ratio (earnings yield, the inverse of CAPE) has a “striking ability to predict returns on the Standard and Poor Index”
The 1998 paper
Campbell and Shiller’s second paper was a very timely piece of work. Being published only 18 months or so before the almighty stock market crash of 2000, the writers had the nerve to state that:
“When stock market valuation ratios are at extreme levels by historical standards, as dividend-price and price-earnings ratios are in the United States today…one might expect…prices will fall in the future to bring the ratios back to more normal historical levels.”.
Today I’ll concentrate on the price-earnings evidence.
CAPE ratios over time as presented in Campbell and Shiller 1998…………….To read the rest of this article, and more like it, subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
