In last week’s post on dynamic withdrawal rates, one of the withdrawal rules we actually liked quite a bit was based on the Shiller CAPE ratio. One disadvantage of any such rule: The CAPE is at a high level by historical standards, 29.30 to be precise as of this morning (March 22, 2017). Today’s CAPE-based withdrawal rates will be very stingy, only around 3% per annum.
So, what to do about our CAPE Fear? One reader recently made an interesting observation: The CAPE uses ten-year rolling S&P500 earnings. So, once we roll out the low earnings from the Global Financial Crisis (GFC) in 2008/9, average earnings should move up again and the CAPE should come down. But by how much? Probably not below 20. Still, how much of a decline in the CAPE can we realistically expect: 10%? 20%? We have to start a new Excel Spreadsheet for that. Let’s get cranking!
CAPE basics
The CAPE stands for Cyclically-Adjusted Price-Earnings (Ratio). Instead of calculating the stock index level over just one single year of earnings (= traditional trailing P/E Ratio), we use a ten-year average rolling window of real earnings. Inverting the number and calculating the CAEY (Cyclically Adjusted Earnings Yield) = 1/CAPE we have a measure that correlates pretty well with the real equity return going forward.
The CAPE definitely has a following in the personal finance and early retirement blogging crowd:
- In our Safe Withdrawal Rate Series Part 3, we showed that the 4% rule works best when the CAPE was below 20 (see chart here). Failure probabilities were elevated when the CAPE is between 20-30 and unacceptably high for CAPE>30.
- MadFIentist has a tool that calculates a safe withdrawal rate for an 80% Stock/20% Bond portfolio. It’s only 3.6%, based on a slightly outdated 2/1/2017 CAPE figure of 28.3, obviously lower now. I personally think that 3.6% is still quite aggressive. In Part 11 of the SWR study, I calculated the CAPE-based withdrawal rates with a multiplier b=0.50 and intercept a=1%, 1.5%, 2.0% and they would imply SWRs of around 2.68%, 3.18% and 3.68% for the three respective values of a. But the 3.68% SWR would be very aggressive. The two other parameter values for a had much better looking past performance.
- Jim Wang at WalletHacks recently had a good post about the CAPE.
- … and many more mentions in the FIRE community. Please let us know if we left out anything obvious.
One small complaint about the CAPE
Professor Shiller won the Nobel Prize. I’m just a guy with a blog, so who am I to complain about the little pet peeve I have with his approach? But for what it’s worth, here’s one complaint and a proposal for a quick and easy fix. Shiller uses earnings figures with a lag of up to 6-months. In his most recent spreadsheet (accessed 3/22/2017), the last quarterly earnings number is for September 2016 (Q3 2016 S&P500 EPS).
What about the subsequent numbers? Well, fourth quarter numbers have not been finalized. We are already pretty late in the reporting season and almost all of the firms have reported their Q4 numbers. Let’s go to the index provider: S&P Dow Jones Indices, click on the item “Additional Info -> Index Earnings” and download a spreadsheet with not just past earnings but also earnings estimates for the current and future quarters. The “as reported” earnings for Q4 are $24.15 for that quarter, or $94.54 for 4 quarters rolling. There is no reason not to figure in that number already. Three of the four quarters are already 100% known and the final quarter is already 98.1% in. I also throw in the Q1 number of $99.69, trusting the analysts’ forecasts of another improvement in earnings. Also, notice that the Q3 figure of $89.09 exactly coincides with the final earnings number from Prof. Shiller. Q2 number from S&P ($86.92) is the same as the June number from Shiller, etc., so this is the exact EPS series that Prof. Shiller uses.
What happens in Shiller’s spreadsheet, when we add the 2016Q4 numbers as well as the 2017Q1 estimate? I added the Q4 number in December, the Q1 number in March and interpolated linearly in between (same method Prof. Shiller uses). See table below. The CAPE will be lower: 29.08 instead of 29.30. Not much but for those who are scared of the CAPE crossing the 30-line we’ve just gotten some extra breathing room! Thank your crazy Uncle ERN for that! For a change, this old curmudgeon is actually a little bit more optimistic than the consensus!
So, equipped with that additional data, let’s plot the earnings vs. index since 2000, see the chart below. Because the index and earnings are on such different scales, let’s plot them in one chart, but with the index level on the left axis and earnings on the right axis. Also notice that the scales are such that a 2500 index level lines up with a $100 EPS level, so when the red and blue line coincide it would mean a 1-year-trailing P/E ratio of 25.
The first thing I notice is that the 10-year rolling earnings number has stagnated for the last few years. And that’s even with the boost we get from adding the six additional months of strong earnings numbers that Shiller ignored. Unfortunately, this “rolling-out-effect” works both ways! Specifically, rolling out the 2007 earnings peak right before the GFC means that the 10-year rolling earnings number has been moving sideways for a while now.
What happens when the 10-year window no longer covers the 2008/9 crisis
Back to the original question. How far can we reduce the CAPE once the GFC is history? Just upfront: There is no single correct answer. Rolling out the old data from 2008 and 2009 means that we have to make assumptions about the new data coming in during the remainder of 2017 and then 2018 and 2019. How do we accomplish this? Simple: We consider a range of different assumptions and see what’s the range of possible CAPE paths going forward. If you don’t like our assumptions, let us know and we can run the whole simulation with your preferred assumptions.
Our baseline scenario:
- From the S&P500 index level of 2,344 (=March 21 closing as used by Shiller) the index price level grows by 5% annually (p=5%). So the nominal return assumption for the S&P would be 7% if we add a 2% dividend yield.
- Earnings will grow by 5% annually (e=5%).
- CPI inflation will run at 2% annually.
Side note: This is Murphy’s Law of blogging: You write a blog post over the weekend and the market takes a dive on Tuesday and Shiller updates his spreasheet with the March 21 S&P500 closing. After I created all my charts and tables! I recomputed the numbers and created new figures this morning, so this is as fresh off the press as it gets!!!
In the chart below, the green dashed line will need a while to catch up. Even when we roll out the GFC, the green line will stay significantly below the red line (by definition because the green is a 10-year rolling average), but even below the red line, so we already know the CAPE will not slip below 25. That’s disappointing!
Next, we plot the historical CAPE until March 2017 and then the projected path for different assumptions about index returns (p) and earnings growth (e), going all the way to 12/31/2027, see below:
- Under the baseline (p=e=5%) we drop to about 26.5 in the year 2020 and settle around 27 later that decade. Still pretty high by historical standards.
- When using a higher growth rate (p=e=6%) the CAPE will drop to slightly above 27 and then settle at above 28. Almost as high as today! There is no real relief from rolling out the GFC!
- When both variables grow at a lower rate of p=e=4% we up just under 26.
- If earnings grow 1 percentage point faster than the index (p=5%, e=6%) we get to slightly below 26 in the CAPE by December 2027.
- If earnings grow 1 percentage point slower than the index (p=6%,e=5%) we will see only a temporary drop to below 28 but then a steady increase to well over 30.
Rolling out the Global Financial Crisis will not reduce the CAPE Ratio by much. A drop in the index level could do that, though that would be very, very unappealing for us in the FIRE crowd. A massive surge in profit growth would be the more pleasant way out of the high CAPE ratio. But hat are the chances for that? Maybe with a corporate tax reform, but don’t hold your breath for that.
A caveat. A big caveat!!!
All of the calculations here assume that there’s no recession and market correction before the year 2027. How likely is that? Well, the longest economic expansion in U.S. history was 1991-2001, according to the NBER. And those were ten years without an economic recession but with plenty of equity market volatility (Tequila Crisis, Asian Crisis, LTCM, Russian Default, etc.). I’m not saying that it’s impossible to have an 18-year expansion from 2009 to 2027, but it would be unprecedented.
Summary
For the last year or so, rolling out past earnings was actually bad for the CAPE. We replaced the peak earnings around 2006/7 with slightly depressed earnings from 2016 (weak energy sector profits). The stagnant 10-year rolling earnings meant that the Trump equity rally pretty much went one-for-one into a higher CAPE.
Rolling out the weak earnings numbers during the GFC will take until 2020 or even 2021. That may lower the Shiller CAPE somewhat, but don’t get your hopes up too high. Absent any big decline in the S&P500, high CAPE ratios are here to stay, somewhere in the range of 26-30. The only way the CAPE can decline again meaningfully without a nasty equity market crash is for earnings to grow faster than the price level. But even that will be a slow and agonizing process.
Are you concerned about today’s high CAPE? Please share your thoughts below!