23 June 2017
In the 1962 thriller "Cape Fear," an ex-convict, Max Cady, stalks the prosecutor who put him behind bars, seeking revenge. The film reaches its nerve-wracking climax on the shores of Cape Fear. In the nick of time, evil is thwarted and justice prevails.
Today, many equity investors are facing their own CAPE fear. Specifically, the S&P500 cyclically adjusted price-to-earnings ratio, known as CAPE, is approaching 30, just shy of its peak before Black Tuesday in October 1929. Those concerns may be misplaced for several reasons, however.
CAPE, most closely associated with the Nobel laureate Robert Shiller, measures the ratio between share prices and 10-year average earnings, adjusted for inflation. Shiller, together with his co-author John Campbell, demonstrated that the price multiple investors are willing to pay for a future stream of earnings and dividends will revert, over time, to its long-term mean.
Using data since the late 19th century, the so-called Shiller P/E (or CAPE) has indeed oscillated around an average of about 16 times the trailing 10-year moving average of real earnings. Campbell and Shiller’s work also showed that high CAPE valuations presaged prolonged periods of sub-par equity returns, while low valuations were followed by eras of above average returns. So even if CAPE may not herald a crash, today's equity investors may still lose sleep over the prospect of desultory performance in the years to come. Yet here's why that worry may be overblown.
First, the 10-year trailing earnings figure includes the profits’ collapse associated with the financial crisis. A long-term moving average is meant to smooth distortions, yet the prevailing CAPE embeds an event unique to the post-war era. Using, instead, trailing earnings from 2010 lowers the CAPE from nearly 30 to about 25. To be sure, U.S. index valuations remain lofty, but perhaps not quite so worrisome.
Secondly, as Shiller himself has noted, valuations per se have little predictive power in the short run. Expensive markets can get more expensive. What matters instead is the near-term outlook for earnings. In this regard, investors can be more cheerful. Aided by profits’ recoveries in energy, materials and financials, as well as by the strong earnings performance of information technology, global profits continue to grow. Underpinning that growth is a resilient world economy, which -- apart from China -- exhibits few problematic imbalances and, for now, scant evidence of overheating.
Third, the sustained high level of profit share in U.S. gross domestic product since the financial crisis suggests that a combination of factors, including globalization, the reduced bargaining power of labor, low interest rates and technological innovation are producing an era of high profitability. An earnings contraction in the U.S., short of a sharp slowdown in economic activity, looks unlikely.
Fourth, in much of the world economy profitability is on the mend after years of sub-par performance. That includes Europe, chunks of the emerging complex and mid-cap Japan. In Europe, for example, earnings on the Eurostoxx 600 contracted at an annual average rate of 7 percent between 2012 and 2016 as recession, bad debt and collapsing energy prices took their toll on profitability. In 2017, on the other hand, European earnings are rising at a clip of more than 10 percent, accelerating to 17 percent year-on-year over the past three months. Stronger growth, a more competitive exchange rate, a slowing of bank provisioning and a recovery of energy-related profits are all contributing to the improved earnings performance.
In addition, companies around the world are exploiting new technologies and are poised to deliver significant gains in revenue, market share and profits for years to come. Simple U.S. index valuations are not representative of the profit and investment opportunities on offer across global equity markets.
Finally, other major asset classes do not offer a compelling alternative for investors. With nominal government bond yields in advanced economies well below rates of nominal GDP growth, traditional fixed-income instruments look, if anything, more expensive than even the broad U.S. equity indexes. The risk for both asset classes is a sudden rise in bond yields (particularly if precipitated by inflation fears). But, for now, that seems unlikely.
So CAPE fear appears excessive. A valuation-based crash is unlikely so long as global earnings continue to grow. In various regions, sectors and individual stocks, valuations, earnings and investment outcomes remain attractive.
If there is a villain in CAPE fear, it is that passive participation in the broad U.S. index does a disservice to investors by obscuring opportunity available to them elsewhere in global equity markets.
Originally published in Bloomberg View 2017. Reprinted with permission. The opinions expressed are those of the author.
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