Stock market bears love the CAPE ratio.
CAPE stands for cyclically adjusted price to earnings ratio.
The basic old PE ratio shows how expensive a stock is relative to the amount of profits it makes in a year. The CAPE goes one step further by using an average of earnings over the previous ten years.
It does this in order to smooth out the effects of the business cycle. It smooths out the effects of the business cycle because, in a given year, the economy might be booming or depressed. That’ll be reflected in earnings.
The CAPE is used to assess whether an overall market, like say that of the USA, is expensive or cheap relative to the long term trend.
Why do bears love it? Bears cite CAPE a lot because it says the US and UK markets are too expensive. The long-term trend in those markets is a CAPE ratio of about 16. The CAPE for the American S&P has been above 16 since 2010; today it’s at 33. The CAPE for the FTSE 250 has been above 16 since 2010 also; today it’s at 24.
That’s pretty compelling evidence on the face of it. There’s no denying stock market valuations are very high relative to the long term trend. In fact, they’ve only been higher in CAPE terms once in the last 130 years — during the Dotcom bubble.
So today I’m setting myself a challenge. I’m going to explain away that crazy CAPE valuation. I’m going to try to convince you a CAPE of 33 is the new normal.
Yields are yields
The first step in my argument involves something called the Fed model.
The Fed model is a simple model of stock market valuation. It says that the yield on stocks (i.e. the dividend yield) and the yield on bonds both move in the same direction. Not that they’re precisely correlated, mind.
The intuition behind the Fed model is simple. Investors are out there choosing between stocks and bonds. A stock and a bond are two different ways to claim a future income stream. So when the demand for “future income streams” changes, you’d expect the price of both stocks and bonds to react in the same way.
This is what we see in real life. Since 1960 at least, stock yields and bond yields have tended to move together. When bond yields are falling stock yields will tend to be falling too.
And another way of saying stock yields are falling, is that stock valuations are rising.
Remember, rising stock valuations is the phenomenon I’m trying to explain here.
So we’re not just trying to explain rising stock valuations in isolation. We’re trying to figure that out alongside the phenomenon of falling bond yields.
Bond yields, by the way, have been falling. What’s more, the fall in bond yields more or less matches perfectly with the rise in stock valuations.
Stock valuations bottomed out at about 6 in the early eighties, which is exactly when bond yields started falling.
So I’m positing that some external thing is causing bond yields to fall and stock valuations to rise.
The two reasons
One answer people tend to give is “loose monetary policy”. But this can’t be right. The timing is wrong. It’s been happening for 35 years or so, long before so-called loose monetary policy kicked in.
I think there are two explanations for what’s happening.
The first explanation is that, starting in the early 1980s, we beat inflation down. Inflation isn’t a problem in the US or UK any more, but back in the 60s and 70s it was a nightmare. In economic theory, the Fisher equation says nominal interest rates are equal to real rates plus the expected rate of inflation. Beating inflation has pushed down yields and pushed up stock valuations.
The second explanation comes down to supply and demand. There’s now much more savings out there hunting for yield. That’s because populations are ageing and therefore saving more. The average age of the population shows a clear upward trend, going from below 35 in 1950 to over 40 in 2015 and almost 50 by 2100.
Here’s how the Federal Reserve Bank of San Francisco put it (emphasis mine):
“Households need to accumulate increased resources through their working lives… Furthermore, as household wealth tends to fall only slowly over retirement, more of the population will be at relatively high-wealth stages of life. This rise in the population’s effective propensity to hold wealth will in turn have profound effects on the financial system, its key relative price – the real interest rate – and the prices of other assets.”
“We find that the ageing of the aggregate advanced-country population can explain 45% of the roughly 360 bp fall in global real interest rates since 1980.”
So there are more old rich people than before. They’re all chasing yield. And they’re pushing yields down/stock and bond prices up.
Old rich people aren’t just buying stocks and bonds. They’re buying property too. According to the Bank of England, ageing populations explain more than three quarters of the rise in house prices.
I’m taking this to mean that the old average CAPE ratio of 16 probably doesn’t apply any more. At least not until the boomers age out of the population in 20 years or so.
So is the market fairly priced? That, I can’t tell you.