Focused Investing Perspectives #56: Capers with CAPE

Summer on the lake at dusk.

What is the meaning of today’s high CAPE values?

We will work our way to the (Shiller) Cyclically Averaged Price-to-Earnings (CAPE) ratio. Start with discussions and advice about investing.

The core of the standard advice, which has worked well in the long run of nearly everyone alive today in the US, is to put money in an index fund based on the S&P 500 and let it sit or add to it. Let’s start with some history of that index:

The easy thing to see here is that there is a lot of growth in the long run. But look more closely.

If you retired in 1999, whatever part of your portfoilo you did not spend lost about half its value for a decade, got back to even in 2013, and took until 2019 to double. The Compounded Average Growth Rate (CAGR) of your holdings was 3%. Whatever money you had left and did not spend for the next 5 years doubled again.

The story is similar if you retired in 1965. It took 18 years to get back to even and another 5 to have doubled whatever money was left. Then it took 7 more years to double it again.

If you retired in 1966 and withdrew 4% each year, increasing the amount with inflation, then you hit a low of a 67% loss in 1981 and only got back to even in 1998, just in time for the next crash. (If you held bonds as part of the portfolio then you did worse.)

The story is similar for retiring in 1929.

What seems clear is that you would like some idea of likely future returns. Then you could decide whether it made sense for you to follow that standard advice.

Earnings Multiples

When the mainstream media discusses how highly the market is priced, they usually discuss the P/E ratio of a stock or an index. For the index overall, this is the ratio of the sum of the prices of all stocks in the index to the sum of their current earnings (either forward or backward). There are some wrinkles about prices we will not dig into.

A very high P/E ratio indicates that a stock or the market may be overpriced. The problem with P/E ratios is that earnings fluctuate quite a bit with business cycles. Here is the total of the real earnings of the companies in the S&P 500:

You can see that these earnings change by tens of percents over periods of a few years, and sometimes suffer brief, deep collapses. Prices are typically 10 or more times current earnings, and sometimes much more, and should logically reflect anticipated long-term, average earnings.

In this light, it is more sensible to compare price to the earnings averaged over a business cycle. This is what Professor Robert J. Shiller did with CAPE, using a ten-year backward average of real earnings (and also adjusting for inflation).

His results are available in a spreadsheet here. This is the CAPE ratio since 1870:

There are still fluctuations, but they are smaller as a fraction. But you can notice that values seem to be higher in this century than in the previous one.

The largest cause of that may be the impact of stock buybacks, which grew prominent after some legal changes in 1982. A company doing significant buybacks causes earnings per share (EPS) to increase.

As a result, a backward average of EPS includes years with smaller and smaller EPS, making the averaged earnings smaller as a sole consequence of the buybacks. The analysis discussed here, for example, found that a company doing extreme buybacks could have a CAPE ratio 50% larger than one doing none.

Here is what you get if you take that literally, and increase CAPE values by 50% prior to 1982:

This does look more reasonable, but still the 21st century CAPE values seem somewhat high. Other attempts to correct for buybacks come up with smaller increases.

One contributing factor may be the interest rate suppression by the Federal Reserve, especially since 2008 but even earlier too. This tends to inflate asset values, including stock prices.

There is a cottage industry seeking “better” alternatives for CAPE. Here is one such paper. It finds that buybacks have increased CAPE by 19%.

The problem of finding an ideal replacement for simple CAPE is an ideal academic problem, with the potential for intense arguments over meaningless differences.

There is also a large amount of work concerning how to use CAPE ratios to predict the future. My view is that doing this with precision is hopeless, but that long-term correlations of CAPE and forward returns do provide useful context.

It is now common to see plots showing the value of CAPE for any specific year and the forward real returns of the S&P 500 over some number of years. Here is one I put together, using the Shiller data:

If we use instead the Adjusted CAPE described above, we get one that is a bit cleaner:

These plots show that when CAPE is 20, give or take, the next ten years has produced highly variable returns. These have rarely been negative and have averaged values in the high single digits. In contrast, a CAPE value of 10 or less has always preceded forward, real returns well above zero, with an average near 15%.

But today we are at the opposite end, with CAPE values above 35. In nearly all previous cases, such high CAPE values have preceded a decade with real losses.

Using the adjusted CAPE plot, we have never seen forward real returns of 10% when CAP has been 28 or higher. And there have never been forward real losses when it was 17 or less.

Conclusions and Perspectives

The conclusion here is that today is an unusually bad time to follow the standard advice. While the future is always uncertain, you could see limited gains or even losses over the next decade on any funds invested today in an S&P 500 index fund.

The usual alternative offered by the advisors is to hold bonds, which seems a better choice today than it did before 2022. This is one way to assure positive returns, and if you buy TIPS you can lock in positive real returns. (See my most-recent previous Perspectives.)

My view: the best way to do that is to buy bonds to hold to maturity. Bond funds are not bonds, add risk of loss of principal, and are unlikely in my view to perform as well. If you decide you want to buy bonds, Fidelity and other brokerages can help you do this.

But also consider dividend paying companies that own hard assets, which is my emphasis here at Focused Investing. Dividends have always held up better than prices during those down decades reviewed above.

A focused portfolio can do much better than the S&P 500 during some intervals. Consider this collection of dividend payers across the decade following 1999:

Even stodgy old Exxon Mobil (XOM) doubled your money, for a 7% gain. Multifamily REIT Camden Property Trust (CPT), not shown, nearly tripled it despite getting themselves in some trouble. Midstream energy firm Enterprise Products Partners (EPD) increased your investment nearly 7x. [I own CPT and EPD at present.]

Mall REIT Simon Property Group (SPG) and Multifamily REIT AvalonBay (AVB) were in between, as you can see. Meanwhile from holding the S&P 500 you would have been down 25% in total return, a rate of -3%.

For the next decade from here, you could, and likely would, do a lot better than the S&P 500 with a collection of the firms just mentioned. Realize, though, that nothing is guaranteed.

Without the interest-rate tailwinds of the 2000s total gains seem likely to be smaller than the ones seen above. Still, my money, literally, says that by owning such companies you will do a lot better than the by owning the S&P 500.

Member News

Looking Ahead

Back from my holiday break, I will put out some articles and notes based on topics that caught my fancy. One thing I am working on is a forward-looking overview on midstream energy firms. My recent, similar look at REITs seemed to be appreciated.

With present times being not-so-hot for investing in REITs for upside, my portfolio has become much more heavily weighted toward energy. I know from the chat room that this is true of some subscribers too.

While I won’t be able to resist probing various REITs, it seems clear that energy investments should become more of a priority. That is my present plan for the rest of the year, unless dramatic market changes take me elsewhere.

Personal Notes

A friend noted that I had dropped this section, which was an accident. So now, thanks to him, it is back.

Summer brings a great deal of beauty to Northern Michigan, along with (unfortunately) too much heat for me and bad air when Canada burns. I focus on the beauty.

My break was good and bad. I got a lot fewer chores done than I had hoped. But I got a lot more research done on things that caught my interest.

I also finished the book Challenger, by Adam Higgenbothom. It covers NASA from the beginning through the Challenger disaster and its aftermath. For me it was an emotional experience. In my big lab days, I knew a lot of managers who would also have made the decisions that killed those people.

My July routine includes paying a lot of attention to the Tour de France, now near the end of week 1. We have already seen some exciting racing. The TV coverage of this event is excellent.

More coming!

Recently published material

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