- CAPE on the S&P 500 has historically had a paradoxical relation to 10 year Treasury Yields.
- When the 10 year yields less than 5%, CAPE increases as the yield rises.
- When the 10 year yields more than 5%, CAPE decreases as the yield rises.
- When the 10 year hits 5%, the most likely CAPE is 33, implying a substantial increase in the index.
Four years ago in May, I published an article here on Seeking Alpha, somewhat pedantically entitled "Shiller's P/E10 Data, S&P 500 (NYSEARCA:SPY) and Risk Premium." Noticing that it still gets the occasional page view, I reread it, and the following caught my eye:
This is a tipping point. If recovery continues to develop favorably, GS10 (the yield on the 10 Year Treasury) will eventually start to rise, whether driven by inflation or by increases in the Fed Funds rate. As that happens, risk premiums will reverse, leading to some very impressive P/E10s. For example, applying the linear regression formula developed in the charts above, at GS10 = 5% the P/E10 would be 36, implying S&P 1,950. If that occurs, you will hear indignant roars of pain from the bears, and joyous bellowing from the bulls.
The index recently passed the 1,950 level, very close to the four years mentioned in the article. If a method gives promising results, I continue to use it. With that in mind, I have updated the thinking from the previous article, to include the implications of QE and the effect of tapering.
It should be noted that the article used Shiller's irrational exuberance data from 1987 forward, since that was the year of the first computer generated crash and marks the beginning of the modern era in the market. It also considered the relationship between GS10 and CAPE under two situations: with the yield over and under 5%.
Here are two charts, demonstrating the relationships as they stood prior to the advent of QE:
The two equations will give the same result with GS10 at 5.3%: CAPE would be normally valued at 33, based on the data selected. However, the advent of QE has changed the rules of the game, and I have accordingly subjected that period to a separate analysis, as follows:
R2 at .33 is unimpressive. Suspecting that the passage of time has been affecting the perception of risk, I introduced it into the analysis, charting the variance from the formula over a period of years. The path is jagged, but the trend is clear: as the low interest regime continues, the market is becoming progressively less fearful and continues to award higher multiples to equities. Here is the chart:
R2 at .83 suggests that time is the governing factor. This quantifies the increasing credence given to the notion that the Fed has your back. What if the Fed is able, over the next five years, to gently guide GS10 to 5%, meanwhile providing macro-prudential regulation in amounts sufficient to avoid another financial crisis?
If we assume that real GDP grows at 2.3%, inflation holds at 2%, and company earnings progress along the same lines, while GS10 obediently works its way up to 5%, the outcome, using the relationships developed and discussed above, is that the S&P 500 will hit 3,340, providing capital appreciation of 11% annualized for the five years involved, in real terms, to which one could add the dividend.
Caveats and Reservations
The inclusion of data from periods before 1987 would seriously reduce the indicated values of CAPE and the S&P 500. QE is a new phenomenon, and we have no assurance that prior relationships will reassert themselves as the Fed takes away the punchbowl. Runaway inflation would trash market valuations.
The world is a dangerous place. Increasing income inequality is exacerbating ethnic and religious tensions. Those who get the short end of the stick under the current neo-liberal economic regime look for someone to blame, and they universally look in the wrong places.
Our leaders, both here and abroad, run the economy and financial system for the benefit of the elite, and apply ruinously inappropriate policies to the problems that confront us. There has been some corrective action in the wake of the financial crisis.
The nice call with which I led off the article was based on the idea that the 10 year would reach a yield of 5% over the coming four years, something that simply did not happen. Of course QE changed the outlook for interest rates.
My Investment Response
The above line of reasoning, plausible as it is, merely develops a rationale for the assertion that the market will someday be as over-valued proportionately as it was under-valued in 2009. The pendulum swings back and forth, from one extreme to the other.
My wife and I have left our index holdings and retirement savings fully invested in equities, while I've handled my discretionary account in a manner that has more or less tracked the market, while holding substantial cash. I sat on the sidelines from 2/14/2013 to 6/14/2013, but got back in the game when it became apparent that things would keep going up.
It would be heart-breaking to sit on the sidelines while the scenario postulated above plays out. Ben Graham, looking at the fact that it would have been possible to exit the market well before the Great Depression hit, wondered why anyone would forgo several years of splendid profits to avoid that debacle. I continue to manage cash in ways intended to avoid the need to liquidate holdings under adverse market conditions, while retaining exposure to high quality US equities.