Recently it seems like the S&P has been making new all-time highs almost daily. So much so that journalists have become bored with constantly reporting the same thing and investors have become desensitized to rising prices. Increasingly this bull market is accompanied by justifications for why the market should remain at these levels or move higher. Many commentators suggest that ultra-low interest rates and a more "reactive" Fed warrant sustainably higher valuations than we've seen historically. In some respects it feels to me like we're in danger of the "new era thinking" that characterized market peaks of the past, when we convinced ourselves that "this time it's different":
"But a new era has come, the era of "community of interest", whereby it is hoped to avoid ruinous price cutting and to avert the destruction which has in the past, when business depression occurred, overtaken so many of the competing concerns in every branch of industry" New York Daily Tribune, 1901
"Stock prices have reached what looks like a permanently high plateau" Professor Irving Fisher of Yale University, 1929
"The full force of monetary policy has been made effective more promptly than ever before to respond to natural demands. This has been done by the timely use of monetary policy and credit" Treasury Secretary George Humphry, 1955
"Changes in technology, ideology, employment and finance, along with the globalization of production and consumption, have reduced the volatility of economic activity in the industrialized world. For both empirical and theoretical reasons in advanced economies the waves of the business cycle may be becoming more like ripples" Steven Weber "The End of the Business Cycle" 1997
A Permanently High Plateau?
As interest rates fall there is some justification for higher valuations since we reduce the rate used to discount future cash flows. However it can be dangerous to take this logic too far for two simple reasons. Firstly, there is little historical correlation between low rates and high valuations. What we can say is that lower rates often precede the formation of an asset bubble (1998, 2003), while an increase in rates is often associated with a bust (1987, 2000). However beyond this observation, there is little evidence of a persistent link. Secondly, just because rates have been exceptionally low doesn't mean they will stay that way forever. As we can see from the quotes above, history is littered with example where expensive markets were justified by reference to temporary or spurious factors, only for those factors to dissipate with time and for markets to crash back down to earth.
Indicators of Excess
As an investor, I tend not to pay attention to market levels. In my experience it is far more productive to focus your work on individual stocks rather than obsessing over the S&P500. Furthermore, comparing an index to historical values has limited value since index composition and market conditions change over time.
Having said that, I believe it pays to be aware when markets start to reach extremes of historical ranges. One of the tools I use to monitor this is the Shiller PE, otherwise known as the Cyclically Adjusted PE (NYSEARCA:CAPE). The CAPE is calculated as the real (inflation-corrected) S&P composite Index divided by the ten-year moving average real earnings. It draws inspiration from Benjamin Graham's methodology of using the ten-year average of earnings as a way to smooth out the business cycle. Helpfully, Robert Shiller regularly updates the data on his website www.irrationalexuberance.com. Here is what the updated chart looks like:
We can see that at the end of October 14, the CAPE stood at 26.5, well towards the top end of the historical range. In fact it has only been at this level or higher in 6% of instances. For me this chart is reason enough to take extra caution when investing in today's markets.
The Controversial CAPE
Critics of the CAPE don't like it because they say it "hasn't worked" in recent years. This is like a smoker of 20 years happily rejecting any link to lung cancer because he hasn't died yet. Regardless of whether the smoker dies, it's not a good idea to continue smoking because the risk increases with every year that goes by. Similarly the CAPE can't forecast the direction of the market, but it does tell us that the risk of investing increases as valuation rises. The work done by Shiller found a negative correlation between the CAPE and subsequent 10 year returns. This conclusion is very intuitive, of course: If you buy into an expensive market you're less likely to generate great long-term returns. Shiller himself was reluctant to quantify the relationship because of the high margin of error. But as a rough guide, if we draw a line through his data, we see that an investor in equities today might expect an annual return of approximately zero over the next 10 years(with a large margin of error of roughly plus or minus 10% p.a!)
I'm certainly not advocating that you down tools and exit the market immediately. I'm only advocating additional caution at these levels. Bargains undoubtedly still exist - as they always have in bull markets. Often these are the stocks that have been left behind in the excitement (In the late 90s, for example, a lot of value was hiding in mining and industrial stocks). And indeed this market may go way higher before it falls back (this was after all the experience of the 1998-99 and 2007). However at this point the intelligent investor will begin to exercise much more discipline than they might in a "normal market". The best returns are likely to accrue to those investors who take a longer view of the cycle and are look beyond the current regime.
"It's only when the tide goes out do you discover who's been swimming naked" Warren Buffett
[This article originally appeared on blog.stockviews.com ]
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.