Warren Buffett famously said, “Price is what you pay. Value is what you get.”
However, over the last 20ish years, it has seemed that regardless of what you pay, value is what you get.
Using the CAPE ratio as a yardstick, starting in 1996, expected future returns started to look bleak. Now anyone who has invested over the last 20 years can tell horror stories about the two most recent bear markets, but this story has had a happy ending. In the last 21 years, the CAPE ratio has been below its long-term average in only 1 year. 1 Year! 2008. That is it.
And despite all of that…
Yes, the S&P 500 was overvalued according to CAPE in 20 of 21 years and still returned 8.28% a year. Was there volatility, oh yes, but the returns are remarkable given everything we have ever been taught about “value”. During this period, a CAPE based strategy that invested in the S&P 500 only when it is below the long-term average and U.S. 10 Year Government Bonds when above, got crushed in terms of returns (It was in bonds every year but 2009).
For comparison, here is what it looks like when you zoom back out to 1929:
Traditionally, using value metrics to help inform investment decisions has helped. That is what makes the most recent two decades so perplexing.
Now for those who have 30+ year time horizons and use an index based buy + hold approach (Bogleheads), valuations and this topic around them, have very little impact on asset allocation decisions. The quote of Buffett’s mentioned above is missing one key piece…“Price is what you pay. Value is what you get over shorter time horizons“.
I still think using longer-term value metrics can help these types of investors with goal planning, savings rate decisions, etc., but from an asset allocation standpoint, it is hard to argue that it matters for those with long time horizons. Here is yet another way to look at this:
Once again we can see that the longer ones horizon becomes, the more appealing stocks become, regardless of current valuation. Unless someone want to actively pay attention to valuations once a year or so, the benefit of knowing them become almost useless. Now as the horizons for our goals get shorter and they enter periods of 20 years or less, it may be time to rethink our hands-off approach. Until such time though, weeeeeee.
Back to those of us that use value metrics to help us with our financial planning and investment decisions. For some, this recent stretch of over-valued markets has caused some to question the validity of metrics such as CAPE. This is a fair question in my opinion and one I have pondered. I am not ready to throw in the towel, but I can see why people are frustrated. One of the most popular arguments is that “markets have changed” and now command a higher multiple (valuation).
In light of that, I had some fun and decided to see what things would look like if instead of a 100+ year average for CAPE to be measured against, what if we used a rolling 30-Year average (I chose 30 simply because that is the typical length of a generation). The following will include a few charts and graphs depicting my tests.
First, the overall data set:
The first thing that stuck out to me when I created this table was that even when using a 30-Year average as our yardstick, it still identified the three periods of major market overvaluation (Late 20s, mid 60s, late 90s) AND the two periods of major market undervaluation (mid 40s and late 70s/early 80s). A good sign.
I decided on three buckets:
- Anytime the CAPE was below its 30-Year average it was highlighted in green (Good)
- Anytime the CAPE was above its 30-Year average but by less than -40%, it was highlighted in yellow (Neutral)
- Anytime the CAPE was above its 30-Year average by more than -40%, it was highlighted in red (Bad)
Much like the normal CAPE testing most people do, results were fairly predictable. When the CAPE was below its 30-Year moving average, future returns were above the long-term average about 80% of the time. When the CAPE was above its 30-Year moving average, future returns were below their long-term average about 77% of the time.
Now the challenge. Much like using CAPE versus its long-term average, unless the CAPE ratio was significantly above its 30-Year moving average, using it as a market timing tool or asset allocation tool is hard to justify for most investors. This has always been the crux of CAPE for most people. The following chart shows what I am talking about:
Until the CAPE ratio signals extreme overvaluation, returns on average are not all that bad. Sure they are “below average”, but not so much so that investors would be screaming for alternatives. What makes this challenging is that, in order to use CAPE as an asset allocation tool you have to be willing to really underweight U.S. stocks at times. Meb Faber has a book around this type of a strategy that I highly recommend, Global Value, but the fact remains, most investors would never even go as far as having a 50/50 split between U.S. and international equities let alone 20/80, 10/90 or 0/100. Here is a post Faber did around his global value strategy. I still recommend the book regardless of your stance on market-timing (Fun global equity history in there), but the post will give you a brief overview of the strategy.
For the record, at the end of 2016, the CAPE ratio was 18% above its 30-Year average…Overvalued, but not extreme.
Of course, there other options. One of those is bonds, but again, as we can see below, unless U.S. stocks are really overvalued, stocks still tend to beat bonds in most 10 Year periods:
So, what is an investor to do when stocks are overvalued?
Well, unless the investor is willing to forgo their U.S. stock holdings as their main holding for some periods in their lifetime, there is not much one can do from an asset allocation point of view.
This is why, in my opinion, valuation based investing gets so much push back. I think most people like the idea of value investing, but do not want to pursue it when the strategy calls for a reduction in their home (favorite) country’s allocation. As I mentioned above, for those with sufficiently long time-horizons, today’s valuations will have a small impact on long-term returns, but for those with shorter time-horizons, say 20 years or less, I offer some caution when you are planning out your current goals.
Note: First, here is an link to Meb Faber’s awesome “Everything You Need to know About The Cape Ratio” page. Second, here is a link to how you can turn the CAPE ratio into reliable safe withdrawal rate in retirement.
The Decade Ahead
I talked about my preference for planning one decade at time in an earlier post, and I want to bring back the indicator I use. It combines two indicators to help frame expected future returns: Household Equity Allocations and Market-Cap to GNP. As of 1/1/2017, the following is a snapshot of what the indicator showed:
And if that was not low enough, here are what U.S. 10 Year bonds are poised to do over the next decade:
For those who are reluctant to consider anything but marginal allocations to anything outside of U.S. stocks and bonds, there is reason to plan for a tough decade ahead. I would strongly caution anyone using a 7.5% return expectation for planning purposes when invested in a U.S. dominant portfolio. If you use the 7.5% benchmark, there is a decent chance that there will be a sizable shortfall between your ending portfolio value and your goal.
As an example, lets say you in your 50s and want to retire in 10 years. You currently have about $300,000 in savings and need to reach $1,000,000 to achieve financial independence. So how do we get there? Well over the long-term, if we invest in 75% stocks and 25% bonds, we would have right around a 8% return. Great. When we plug our assumptions into our handy planning tool (You can find this sheet from this post here), we find that we need to save about $25,000 a year:
Now what happens if this 75/25 portfolio returns what it is expected to return? About 3%…
That “dream” scenario can very easily turn into this:
Ho-Hum, just a $300,000+ shortfall…
For comparison sake, in a “Good” scenario, we are still looking at a shortfall of about $200,000. In a “Best” scenario, we are looking at a shortfall of about $70,000.
So what are we supposed to do? Well we have four options in my opinion, none of which will sound fun to you:
- Save more
- Delay short-term goals
- Decrease expectation of short-term goals
- Increase risk allocation (More stocks, small-cap value stocks, international and merging value stocks, etc.)
The most realistic and encouraged options in my opinion are 1, 2, 3 or a combination of those. Option 4 could be a challenge, as going this route could push you beyond a risk level you are comfortable with.
For the goals that are 30+ years away, keep buying up stocks whenever you can, but please make sure you have an actual plan for your shorter-term goals.
Have some fun out there!