We’ve been hearing experts predicting a crash in markets for years now, yet all indices seem to just keep going up. This brings about the question, how do we know when the stock market is overvalued or undervalued? This also leaves us with the big question, do I put my money in now or should I be waiting?
One very important tool to determine this is the Shiller PE ratio (also called the CAPE Ratio). Let’s start with a price to earnings ratio, what is it? It’s basically how much bigger the price of a share is compared to the company profit for that share. So a price to earnings ratio of 10 means that if the company earns 100M in profit per year, it is being valued at 1B. Basically, the higher this figure, the more expensive stocks are. The Shiller PE is very similar, except that the average profit over a period of years is taken rather than for just 1 year, and it is also adjusted for a world where there is no effect of inflation, but it basically works the same, the higher it is, the more expensive stocks are.
The chart above shows how the Shiller PE is very high right now, it’s only been higher once in the last 150 years. It is generally around 17 on average, but is more than twice that now. Shiller is the name of a famous researcher who invented this statistic and is widely known in finance. He then tried to see if this CAPE ratio can predict future returns. It actually could do relatively well. He found out that, on average, the higher the ratio, the less the average stock market return was over the next 10 years, not good news for today’s market.
The below chart is a bit confusing, focus on the green line and blue. The green line shows the average return over the next 10 years you would have expected given the CAPE ratio at that time. The blue line shows the average return that actually happened. You can see that they move relatively in sync, showing how a higher CAPE ratio results in a lower expected return for the next 10 years. Today’s CAPE ratio implies that the average stock market return in the US will be 0% over the next 10 years, quite shocking.
However, there is one key distorting factor, interest rates. How do interest rates affect stock prices? Basically, the 2 major types of investments are stocks and bonds. Bonds are like loans with a certain interest rate. Stocks are usually riskier than bonds but have better long term returns to compensate for this. If interest rates go very low, then investors are willing to accept less yearly return on stocks. So, for example, if you can get a 3% return on bonds, you might be willing to accept 6% returns on stocks. However, if the interest rates moved down and the return on bonds became 2%, maybe investors would be willing to accept only 5% returns per year on stocks. Overall, this means that lower interest rates push stocks up, and higher interest rates push stocks down.
Now, what happened over the last 20 years with interest rates? The below chart shows the US interest rates over this time. Interest rates have gone to 0, pushing stocks to higher levels. Low interest rates mean that markets will accept the situation that stocks trade at a higher CAPE ratio than in the past. If interest rates had to rise by a lot, we could indeed see the case where investors are no longer willing to accept a high CAPE ratio and thus stocks will fall.
So what did Shiller do to account for this? He made a version of the CAPE ratio that adjusts for interest rates. It’s called the excess CAPE yield, which involves the earnings over and above the interest rates in the market, rather than just flat out taking the earnings of the companies. This is also different from the CAPE ratio in the sense that it represents the extra returns over and above the interest rates that you’d receive if you bought the company, purely from company profits. This new ratio predicts market returns over the next 10 years much better. The below chart shows the excess CAPE yield and the actual stock market return over the next 10 years tend to move very much together. This implies that, given the excess CAPE yield of today, the average market return per year for the next 10 years is likely to be about 3%. Still low but better than the 0% when not adjusting for interest rates. But this has one big assumption, that interest rates will not change significantly. If rates had to go up, then returns could be a lot worse than 3% per year.
So that leaves us with the question, does this mean we should not invest, given the dire return predictions? I would say no, because even though long term potential is not that good, we’ve been expecting bad returns for a long time and returns just keep getting better. It is very hard to time when things will get sour. The best thing to do would be to invest a bit every month no matter the price, however, with one caveat. Keeping some reserve cash to be opportunistic in the future will help a lot. If markets had to crash and Cape Ratios had to go a lot lower, that’s your time to bargain hunt. People sitting on cash when the best opportunities arise can get the best bargains.
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