Why Valuation Matters – GRAVITY
Those who have spent time reading these weekly notes over the past few years are aware that when valuations become extended, we advise people to lower their return expectations and prepare for potential volatility. The last time we directly communicated the specific data that we are going to update in today’s note was at the beginning of 2022 ─ when valuations were also quite high. Shortly after we wrote that note, the market experienced a substantial correction as the Fed aggressively raised interest rates to combat inflation. But the sell-off did not stick. The market has been remarkably resilient, making new highs regularly in 2024. Presently, the stock market is approaching valuation levels resembling those of late 2021. We are not saying today that a market correction is imminent. But, given the currently high stock valuations, it will be difficult to accumulate equity returns at or near historical norms over the next several years.
Before we show the relationship between equity market valuation levels and subsequent returns, we want to show you the entire available history on market valuation levels using the Shiller CAPE ratio. As a reminder, the Shiller CAPE ratio is a cyclically adjusted PE ratio developed by famed Yale University economist Robert Shiller. The Shiller CAPE ratio is a reliable and durable predictor of future equity returns. Here is what the ratio looks like over its entire history dating back to the late 1800s.
As can be seen, over the entire history of the CAPE ratio, it has been higher than it is today only twice. Once in 2000 during the dot com era, and again at the beginning of 2022. The current 35 reading is third, even exceeding the roaring 1920s. So, what usually happens to equity returns in the years following such a valuation spike? That is what the remainder of this weekly note addresses.
Beginning in 1950, we take the monthly CAPE ratios for the S&P 500 Index, and then ask what happens to S&P returns over the ensuing 3, 5, and 10 years. We will present three charts relating specific CAPE readings to subsequent annualized returns. The first chart shows all CAPE readings with three-year forward returns, the second shows all CAPE readings with five-year forward returns, and the third chart shows all CAPE readings with ten-year forward returns. Here are the charts:
One can see, plainly, why we caution lowered expectations when confronting the CAPE valuation levels that we are seeing today. With a current CAPE of 35 and using history as our guide, the S&P has a reasonable chance of making an annualized return of between 5 and 10% over the next three years. But the clock is ticking in a fashion that resembles either the game of hot potato or musical chairs. It seems only a matter of time before the music stops. And when we turn our attention toward the five-year forward returns, it can be ominous.
Historically, we have never seen positive forward five-year returns from the current CAPE levels. We might have a couple of years where we still eke out some returns, but it seems highly likely that five years from today returns will be tepid at best and possibly negative. From these levels, historically all returns have been negative over the subsequent five years, so proceed from here with caution!
Things improve when we move from a five-year window to a ten-year window when it comes to prospective equity returns, but it is not a significant improvement. Using history as a guide, the best we can expect to do is a five percent annualized return from here over the next ten years. And here is one more cautionary remark. If the CAPE ratio extends from here to near forty, we could then be looking at negative returns to stocks for ten years. So, these valuation levels merit careful consideration.
There is always a chance we could defy gravity, and markets could keep moving higher. But we would not bank on it. If you are approaching or in retirement, it is probably a good idea to revisit your risk tolerance and portfolio allocations. We at WealthPlan have portfolio strategies that can help position your portfolio for the potential of heightened volatility and downside shocks that may be ahead of us. Downside managed strategies might be the right thing for you to consider at this time.
DISCLOSURES
The S&P 500 Shiller CAPE Ratio, also known as the Cyclically Adjusted Price-Earnings ratio, is defined as the ratio the S&P 500’s current price divided by the 10-year moving average of inflation-adjusted earnings. The metric was invented by American economist Robert Shiller and has become a popular way to understand long-term stock market valuations. This ratio is used as a valuation metric to forecast future returns, where a higher CAPE ratio could reflect lower returns over the next couple of decades, whereas a lower CAPE ratio could reflect higher returns over the next couple of decades, as the ratio reverts to the mean.
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