Halls of Shrewd'm / US Policy
No. of Recommendations: 27
I was intrigued by Jim's work on CAPE's accuracy to predict future long-term S&P500 returns:
https://www.shrewdm.com/MB?pid=391512190 post #448 in thread
So I dug into the issue a bit myself using Shiller's data back to 1871 (Jim considered 1995-onwards). I basically reproduced Jim's result, then looked further back in time. Below is my 5 page report. You can get the gist by just looking at the pictures and reading text immediately above and below, or read on more for more detail
https://www.dropbox.com/scl/fi/45ye2kdeeliso6y3kd4...The Mr. Finke that I refer to is a finance person who wrote a piece on CAPE, "The Remarkable Accuracy of CAPE as a Predictor of Returns”, claiming that it's remarkably accurate well before the 1995-onwards time-frame that e.g. Jim used. But I don't reproduce his result. Instead I find that 'Rsqr', the square of the correlation of CAPE and Shiller's future ten year returns, plotted over time using a rolling 15 year window of data, has great periods like 1995-onwards and also previous great periods, however it also has periods where Rsqr falls off a cliff. I tried to avoid making an error in the analysis, but it's possible.
No. of Recommendations: 16
For me a key factor is how the returns from a given start date are calculated.
If you take a return of precisely 10 years, then the result you get is at the mercy of the (more or less random) valuation level on the precise ending anniversary.
So, for all intervals with an endpoint in a period of volatile markets, you get almost no signal.
I personally correct for this by calculating forward returns with a smoothed end point.
For example, take the annualized rate of return for all possible holding periods 6 to 14 years later, and average those, and call it the 10 year forward return.
This gets rid of all endpoint squiggles, while maintaining the precise information about the valuation ratios on the start date of each hold.
The other big thing, of course, is the very long run trend of increasing valuation multiples. I don't think there are many very satisfying explanations for this, but one can't ignore the fact that it happens. There was a time when a CAPE of 17 was expensive, and in the last few decades it would count as cheap. So any analysis that does not include sub segments, or a correction factor for the long run trend, is going to have low apparent predictive power.
For example, someone bending over backwards to find some sense in it all would look not at the predictive power of a particular CAEY number (I say CAEY rather than CAPE because you can't meaningfully do arithmetic with P/E ratios), but the predictive power of a day's CAEY number relative to (say) the average trend earnings yield in the prior 40 years or the long run linear best fit line of date versus CAEY. i.e., rather than checking whether CAEY is above or below 5%, was it above or below the trend of CAEY through time? I did my study for only 1995 and later because, IIRC, it was in the discussion of whether CAPE had had any predictive power after it was popularized, and also because using a shorter interval of ~30 years gets rid of most of the problem arising from the fact that markets were very much cheaper a century ago. The amount of history you consider is the main determinant of what level you consider "normal".
Jim
No. of Recommendations: 7
If you take a return of precisely 10 years, then the result you get is at the mercy of the (more or less random) valuation level on the precise ending anniversary.
Yes, I averaged in another section, it's a good idea. But for 1995 onwards, the results are great whether you average or not.
But I find results in previous 15 year periods (1995 to now is 18 years, I used 15 as a nice number for a sliding window) are often equally great, but sometimes fall off a cliff. See my plot of Rsqr (correlation of future ten year return and present CAPE) as you slide a 15 year window back in time.
I'll have more on increasing multiples and other things in Part II.
No. of Recommendations: 5
BTW, my phrase "1995 to now is 18 years" is not an arithmetic slip.
I was referring to the fact that it's 18 years to 2013, and 2013 is the last date for which you have data for 10 year forward returns, given that my analysis was done at end of 2023.
Jim's point on averaging is a good one in general, but the scatterplot I showed for the 1995 onwards period is so good w/o averaging that it'd be impossible to improve on it much. The most negative possible correlation is -1 and the scatterplot has correlation -0.926
The full period from 1871 was done both with, and without, averaging of endpoints.
Valuation multiples do change, I go into that in part II. Also trends.
CAEY: Jim, are you defining it as 1/CAPE, or something else?
No. of Recommendations: 6
Excellent study, Ted. Thoroughly enjoyed visiting "CAPEtown" with you, and loved your analogies. I have long suspected there there were "dark alleys" with using CAPE, and you helped shine the light on these.
I've always wondered - what are you going to do about a high CAPE value if you are a Millenial or GenZ investor with 30 years to go before retirement? Are you going to stop maxing out your 401K into an index fund every paycheck? IMO, that would not be advisable.
The next 10-year period may deliver lower than average market returns. Or it may not. As you showed, CAPE was not able to predict that consistently.
Along similar lines, a paper came out recently - "Why the High Values for the CAPE Ratio in Recent Years Might Be Justified"
The author says "Relying solely on historical CAPE averages to forecast equity returns may therefore prove unreliable. The findings in this paper indicate that investors should incorporate multiple factors, including required return and expected earnings growth, when forming capital allocation decisions across asset classes. Rotating out of the equity market simply because the CAPE Ratio shows that the equity market is too expensive might not produce the desire outcome investors hope for."
https://www.mdpi.com/1911-8074/16/9/410In other words - don't time the market!
No. of Recommendations: 2
I've always wondered - what are you going to do about a high CAPE value if you are a Millenial or GenZ investor with 30 years to go before retirement? Are you going to stop maxing out your 401K into an index fund every paycheck? IMO, that would not be advisable.
I think they need to keep saving, perhaps even more because of the lower predicted returns, but that doesn't mean they have to put it all into an S&P500 tracker. I'm in the UK, so not an expert on the US market, but midcaps (S&P400) look noticeably cheaper than the 500, so monthly averaging into there would presumably have less downside risk. (I'm thinking that given current valuation levels and as a general strategy, protecting the downside is the most important thing.) It feels like most index investors in the US are buying the 500, which might be part of the reason it's more expensive than the mid-caps. They could also put some money into bonds / treasuries. e.g. a traditional 60/40 split, or an 80/20 split, but using the S&P400 instead of the 500. It seems clear that this is probably not a good time to be 100% in rich US stocks.
SA
