There has been much debate in recent months as to the attractiveness of US equities in terms of valuation. Much of this debate has hinged upon comparison of price to earnings, risk premium or cyclically adjusted price to earnings (NYSEARCA:CAPE), relative to historically average valuations.
In terms of risk premium and price to earnings, equities certainly appear to be priced in line with historical trends, while the present CAPE ratio of the market stands at an elevated level of approximately 21 relative to its longer term mean of 16.5. This apparent overvaluation of US equities has led followers of the CAPE methodology to conclude US equities are in want of a 22% correction in the near term, a correction that would correspond to a price level of approximately 1050 for the S&P 500 index.
There is no doubt that the CAPE is a useful valuation metric, as there is little doubt that equities in the aggregate are hardly cheap. However, the question of whether a near term price correction awaits investors in US equities is a more open ended one and it is a question that the CAPE ratio is ill suited to answer.
Why is the CAPE ill suited to answer whether or not equities are due a near-term price correction? To answer this question, the level of the CAPE ratio was plotted against 12-month performance of the S&P 500 index since 1881. A graph is also provided to compare the 10 year annualized return that Shiller has put forward in order to advocate the utilization of the CAPE ratio.
The conclusion from comparing these graphs is that the CAPE has significant impact on expected returns over a long period of time. Furthermore, the ratio is hardly full proof. The five most disastrous 10 year annualized returns on the chart correspond to average or below average CAPE ratios. These years were 1972 (CAPE = 17.26) and 1909-1912 (13.78 > CAPE > 14.75). Moreover, the overall trend is very rough as shown by the R2 value of 0.166. The top graph shows absolutely zero correlation. In other words, your return in the stock market over the course of a year has no correlation with the CAPE ratio (incidentally 2 and 5 year intervals also have very low statistical correlation). Plotting the current price to earnings ratio of the market against forward returns leads to the exact same finding.
It is quite easy to see why this is the case if you consider the trading mentality of market participants. Positive surprises cause investors to buy. For example, investors will buy regardless of price if an earnings report exceeds expectations, or if BLS data showed better than expected hiring in the jobs market. Negative surprises cause investors sell. Investors don't stop and think, "the market is trading below its long term CAPE average, therefore I should hold." No, they see a bad jobs report or a poor earnings surprise and they sell regardless. Since the CAPE is not correlated to positive or negative surprises, its level is not correlated with short or medium term stock performance.
So if the CAPE does not give information as to whether stocks should be purchased (or held) at current price,s is there a better metric for shorter holding periods? Actually there is a stronger correlation over a two year time horizon by analyzing the ratio of real bond price (I use the long-term treasury mutual fund VUSTX) to the real S&P 500 price. VUSTX strongly outperforms during periods of flight to quality and risk aversion. Similarly, the overall stock market declines during such periods. Thus the ratio of the two gives a number that tells you whether Mr. Market is currently in a manic or depressive state and by how much. The current ratio of S&P 500 Real Price/VUSTX is 100, which predicts a 2 year real return of 36.7%. It is worth noting that 100 is strongly bullish from a contrarian point of view. Since 1989 there has no monthly period when purchase of the market would lead to a loss with a holding period of two years given the current ratio. Also, the statistical correlation with forward two year returns is superior to the CAPE method for predicting 10 year returns (R2 = 0.174 vs. R2 = 0.166 for the CAPE methodology).
But why should a comparison of stock to bond prices be more predictive than looking at stock prices alone? In my opinion, this correlation is highly logical when one considers how market participants react to negative news. As the stock market trades down, the bond market trades up, performance chasing is rampant for retail and institutional investors alike. However, when the tide inevitably turns in the opposite direction the exact opposite effect comes into play and stocks are bid upward at the expense of bonds. Over a time period of two years it is unlikely that the present flight to quality will not reverse itself.
As many investors have discovered over the years, it is highly dangerous to purchase stocks from Mr. Market when he is in a manic state. Inevitably, the buyer will end up paying too much and experience regret further down the road in the form of a capital loss. While prices could always trade lower in the short term, it is my contention that the current state of Mr. Market leans toward the depressive side. Thus many stocks are available for purchase well below their fair value.
The current situation in Europe and the United States should not dissuade investors into fleeing equities at the present time. Short term price movements are random as is aptly demonstrated by the failure of actively managed hedge funds or mutual funds to beat their benchmarks during the 2011 calendar year. The failure of the ECRI in their blown recession call around September 2011 leads me to the conclusion that average investors have little chance of beating the market by analyzing either the US business cycle or European events.
It is also worth noting that the current CAPE contains averages from years with two significant recessions (2002 and 2008), which historically is anomalous. If one assumes that the current year will end with earnings in line with analyst estimates the CAPE ratio would be closer to 19, hardly cheap, but hardly massively overvalued.
Based on historical data, it seems unlikely that we have seen a top in the current bull market. More conservative income oriented investors could take long positions in low beta equities with lower European exposure such as Chevron (NYSE:CVX), General Mills (NYSE:GIS), Kinder Morgan Energy Partners LP (NYSE:KMP), PepsiCo (NYSE:PEP) and Target (NYSE:TGT). More aggressive investors should be drawn to cyclical stocks such as Caterpillar (NYSE:CAT) and Cummins (NYSE:CMI), whose valuations are highly attractive at the present time. As a hedging strategy, I view VCIT (Vanguard Intermediate Term Corporate Bond ETF) and VMATX (Vanguard MA tax exempt Municipal bond fund or a comparable mutual bond fund for non-MA residents) to be more attractive than Treasury bonds at the present levels of valuation.
Note: The S&P500/VTUSX method was previously reported by Matt Busigin.
Disclaimer: Always perform your own due diligence and carefully weigh your tolerance for risk before taking a long position in any stock.