Curb Your Enthusiasm

The stock market is on fire and the Mag Seven are rising in anticipation of strong AI induced earnings gains. Nowhere is this more apparent than in the PE valuations of large cap technology stocks like META, Alphabet, Nvidia, Amazon, Apple, and Microsoft. With all the hype and stratospheric expectations, sometimes it is important to take a more sober look at long term stock market patterns to gain a dose of realism.

The Shiller CAPE Ratio developed by Yale economist Robert Shiller is viewed by many as an important indicator for future stock returns (we at WealthPlan included). Firstly, it’s important for readers to understand what the CAPE Ratio is before delving into its predictive capacities. The CAPE Ratio is the “Cyclically Adjusted Price-to-Earnings” (CAPE) of the S&P 500 Index. Officially, the CAPE is defined as price divided by the average of ten years of earnings, adjusted for inflation. Instead of using a single measure of earnings in any calendar year, Shiller “smooths” those earnings to reduce any cyclical noise that may be imbedded in any single-year earnings number by using a ten-year moving average of earnings.

Some financial practitioners are critical of this method and take issue with the “handicapping” of current earnings by “weighing them down” with past lower earnings periods. Afterall, the logic goes, corporate earnings in aggregate have an upward drift that is not fully being captured in the Shiller method. While many subscribe to this criticism, we do not. First, if there is a bias downward, this bias is consistently applied through the entire history dating back to the 19th century. Because of this, statistical research findings are still reliable. Second, we find credibility in the thinking that earnings go through periods of accelerating and decelerating growth. Markets have exhibited a tendency to “overreact” to these highs and lows, which is exactly what the smoothing approach seeks to ameliorate. With that, let’s look at the current CAPE relative to its history below.

As of February 9th, the CAPE ratio on the S&P 500 was registering at just under 34. It is lower than it was two years ago and lower than it was in 2000, but these levels are very high relative to the entire history, particularly with interest rates being up dramatically in the past two years. The recent market rally has taken the CAPE ratio up to levels that are historically associated with tepid forward returns.

The big question that CAPE helps answer is what kinds of forward stock market returns are associated with the different CAPE levels. We produced the chart below for the S&P 500 Index using January first CAPE ratios and January first index levels starting in 1985 and up through the present day. We then calculated the subsequent annualized five-year forward return associated with each CAPE measure. This is what it looks like:

One can plainly see in the chart above this basic relationship: the higher the CAPE, the lower the subsequent returns. The best markets have performed in the five years after a reading similar to the one we are seeing today is 7.5% (while a negative return is more than a modest probability.) Long term investors with a reasonably long horizon need not panic here. But one thing seems clear when it comes to expectations for future stock market returns from here: CURB YOUR ENTHUSIASM. It is likely that 5% to 7.5% annualized returns from here is probably the best we can expect to do in the next five years and negative returs are possible. In the long-run, valuations matter!

The S&P 500 Index, or Standard & Poor’s 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S. The S&P 500 index is regarded as one of the best gauges of prominent American equities’ performance, and by extension, that of the stock market overall.

Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.