Nervous about sky-high stock prices? Five ways to cope with “CAPE Fear”

Another month, another record close for the major stock indices on November 30. How long can this go on? Is this a bubble? The Shiller CAPE Ratio certainly looks “bubbly,” now that it’s solidly above 30, see the chart below. It’s almost as high as in September 1929, right before the crash. And significantly above the 2007 peak right before one of the stock crashes in recent history. Should we scale back our equity positions now? It sounds tempting now that we are so close to retirement. As of Wednesday morning, while doing the final edits it definitely looks as though stocks are off to a bumpy start in December!

CapeChartNov2017
Shiller CAPE: Closing in on the 1929 peak!

But hold your horses! Let’s look at some of the reasons not to throw in the towel yet…

1: The Shiller CAPE is notoriously unreliable for timing the equity market exit!

What exactly constitutes a CAPE high enough to scale back my equity position? Should we take the pre-financial-crisis peak of 27.55? We blew through that number in December 2016 and had we gotten out of equities back then we’d have missed 20% worth of returns year-to-date. Likewise, if you think that today’s CAPE of 31.3 is high, would we have sold equities back in the 1990s at a CAPE level of 31.3? That would have been in June 1997 when the S&P 500 stood at 885 points. The S&P had another 79% to go before the peak (dividends reinvested). The CAPE is not exactly the best measure for pinning down the equity market exit! Of course, in its defense, I would still maintain that the Shiller CAPE measure is a nice tool for adjusting the safe withdrawal rate, see Part 18 of the Safe withdrawal rate series!

2: When would I move back into stocks again?

One advantage of not selling stocks right now: I don’t have to worry about when to get back in again! Remember, we can’t sustain a 50 to 60-year horizon with U.S. Treasury bonds yielding slightly more than the rate of inflation. Eventually, I have to shift back into equities. But when? It turns out the CAPE is just as useless for timing the entry as it was for timing the exit. As we can see from the chart above, the CAPE didn’t even drop below 20 after the dot-com bubble. After the global financial crisis, we dropped below 15 but only very briefly before jumping back to above 20. So, this widely used CAPE rule-of-thumb out there – 10 is cheap, 15 is normal, 20 is expensive – would have deprived us of some pretty nice stock gains since 2010. In fact, in case of a normal, garden-variety recession and stock market correction in a year or two we likely will not even drop below 20. It would be just too risky to miss the entry point. I know folks who got out of stocks in 2015 during the whole mess with the Chinese devaluation. Good timing because in early 2016 you could have reentered when the S&P500 dropped to the low-1800s. But if you missed that reentry point, and a lot of folks did because they were nervous and didn’t want to catch the “falling knife,” then they would have potentially missed out on a lot of nice gains since then!

3: Depending on the measure we use to value the S&P, stocks aren’t even that expensive!

One problem with the historical CAPE comparisons: If we think that stocks are expensive, that’s fine. They may very well be. But after we sell our stocks, where do we put the money?

Where are the cheap undervalued assets to invest in after we sell stocks?

Bonds are expensive, too. Yields are still extremely low by historical comparison and with the U.S. Federal Reserve on the path to raising interest rates once more next week and three times next year, bond prices will potentially come under pressure. So the Shiller earnings yield (CAEY = 1/CAPE) may be low but relative to the bond yield it doesn’t look so bad.

So, let’s do the following experiment: Let’s look at not just the Cyclically-Adjusted Earnings Yield (CAEY) but also the CAEY minus the 10-year U.S. Treasury Yield and the CAEY minus the 3-month T-bill rate and compare the most recent value with the historical distribution, see table below. As we already knew, today’s CAEY (1/31.3=3.19%) is extremely low, 3.21% below the median and lower than in 97.1% of the observations in history. CAEY minus the 10-year yield is still low by historical comparison, but not outrageously so; 28% of the time it was even lower! Finally, the difference between CAEY and the 3M T-bill rate is pretty close to the historical median. I don’t want sell stocks and rush to bonds or cash that have below-average expected returns as well!

CAPE vs interest rates - Nov2017
Earnings yield and earnings yield relative to interest rates. The CAEY doesn’t look so elevated relative to 10-year government bond yields and it looks close to normal (median) relative to 3-month T-bill rates!

4: Corporate Earnings Growth looks very solid

The CAPE can fall if the index falls and/or earnings per share (EPS) rise. And recall that EPS in the CAPE construction refers to the 10-year rolling average inflation-adjusted earnings. Over the next 2 years, we will be rolling out some of the really awful earnings numbers from the Global Financial Crisis. And that would be true even if there was no earnings growth at all. But looking at the earnings projections from S&P Dow Jones (click on menu “Additional Info”, then “Index Earnings” to download the spreadsheet) EPS is projected to grow to above 130 by the end of 2018 and applying some moderate 8% growth in 2019, we’ll get to above 140. When we’re replacing an earnings number of 20 or below with a 100+ annual EPS, we will drag down the Shiller CAPE. Using the earnings projections in the chart below, I calculated the Shiller CAPE at the end of 2019, for a few scenarios of S&P500 returns:

  • S&P500 returns 4% p.a. (2% price return, 2% dividend yield), i.e., the Jack Bogle expected return assumption: The CAPE would drop to 25.4!
  • S&P500 returns 5.75% p.a. (3.75% price return, 2% dividend yield), i.e., the Big ERN return assumption: The CAPE would drop to 26.3!
  • S&P500 returns 10% p.a. (8% price return, 2% dividend yield): The CAPE would still drop to 28.6!
CapeChartWithForecast_Nov2017
The average 10-year rolling EPS is bound to increase if we replace the horrendous 2007-2009 earnings with today’s figures. Source: Robert Shiller, S&P Dow Jones Indices, own calculations.

So, back to the issue of finding the right reentry point: If I’m getting out now to wait for a lower CAPE ratio down the road, I may get an entry point of somewhere between 25 and 30 in 2019, but still miss out on some pretty solid equity returns along the way! How crazy is that?!

5: Corporate tax reform

Corporate profits already look strong now. Forecasts for profit growth will be revised upward even more if and when tax reform is passed, hopefully in a week or two. I have heard estimates of a 10% jump in corporate profits. Because of the slow-moving 10-year average EPS in the denominator of the CAPE construction, this will take – you guessed it – 10 years to be fully priced into the CAPE. Along the way, there will be folks complaining about the sky-high CAPE but that’s because they only look at the past 10 years of earnings while ignoring the future path. When I drive I look out the front window 99% of the time. Only 1% of the time, I check the rear view mirror!

Conclusion

I agree that stocks aren’t cheap. But we still have an equity-heavy portfolio and we still invest new money in stocks. To be sure, we have also invested some of the new flows into some alternative asset classes: Real Estate and Options Trading. But the growth engine for the long-term in the ERN portfolio will always be the equity portion!

We hope you enjoyed today’s post. Please leave your comments and suggestions below.

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38 thoughts on “Nervous about sky-high stock prices? Five ways to cope with “CAPE Fear”

  1. Awesome insight into yet another reason to not bother timing the market! I’m 26 so I’ve got 75+ years for this money to last, and I definitely need the stock exposure. No way am I going to bother trying to time the market, so I love the positive reinforcement. 🙂

    Liked by 4 people

  2. Big ERN, great analysis, as always. We all know a correction WILL come at some point, so it’s best to build it into our plans. We’re 60%E / 30%B / 10% Alts. Most importantly, a portion of our “30% Bonds” is in very short term bonds and comprises our “Bucket 1” reserve for 3+ years of living expenses. The market correction would have to be a real killer to outlast the “dry powder” we’ve set aside for 3-5 years of spending requirements. It may be painful, but we should be able to ride out all but the worst, and minimize our Sequence Of Returns risk.

    Liked by 1 person

    • Just to be a contrarian on this… If I was closer to retirement I would consider longer bonds not short (but not as much as 30%). Because….? they provide a much better tail risk against the equity drawdowns that you fear. Whenever there is market panic people buy Treasuries. And they also provide a higher yield than the negligible yield on short bonds.

      However the risk here is that rates rise faster than is currently priced into the curve. Given the FED is now pretty good at telegraphing its intentions to the market then I don’t think there is high chance of that happening from monetary policy. I guess there is still risk from fiscal policy driving higher inflation expectations, but I think we saw all that happen last November, and there will be no more surprises on the horizon there.

      Liked by 1 person

      • Good point. But it depends on what kind of recession we get: deflationary (then bonds help) or inflationary (CPI rises, Fed raises interest rates, sinks both stocks and bonds). If it’s the latter, you’re better off with just holding bonds that hedge/fund the cash flows for the next 3-5 years. I can see pros and cons for both…

        Liked by 1 person

  3. Couldn’t’ agree more. Sure the CAPE is high, but it could revert to the mean after a quick crash, or slowly over time as earnings catch up with prices. Either way, I’ll sleep well at night knowing that the biggest risk to my portfolio (myself) remains out of the loop 🙂

    Great analysis!

    Liked by 1 person

  4. Another point you didn’t mention: As the WSJ article below points out, CAPE is distorted because the definition of GAAP earnings has changed over the years. Also, it is based only on the S&P 500, and not on the total US stock market. If a consistent and broader measure of earnings is used over time, the picture looks much different.

    https://www.wsj.com/articles/powerful-market-indicator-flashes-sell-heres-why-it-can-be-ignored-1475687806

    Liked by 2 people

  5. I agree with all of the above. I took a slightly different approach as I am 3 years from full retirement (57 now) and working very part time now. As my plan for asset allocation is to follow a ‘reverse glide path’ I took this opportunity of high CAPE to rebalance to 50/47/3 stocks bonds cash over the past month. When I retire I will then greadually increase my stock exposure back to 65-75% over 10-12 years. For younger people ignoring the market noise is almost always the best course and what I advised my kids to do.

    Liked by 1 person

  6. Hi ERN,
    Really enjoy your Wednesday posts. With low inflation and only gradually rising rates, can we lever bonds (via futures) to make a safe distributing portfolio?

    10Y: 2 x 2.35% minus 1.5% inflation = 3.2% real!
    5Y: 2 x 2.15% minus 1.5% inflation = 2.8% real.

    Thanks,
    Kevin

    Liked by 1 person

    • You can buy Treasuries on margin and the most efficient way to do so is through futures. Buying physicals (e.g. bond ETFs) on margin is not recommended at most brokerage companies is not advised because the margin interest is wiping out the entire excess return.

      But careful! With futures you can’t just buy a 10Y and hold it to maturity. You have to roll the contract every three months into the next expiration. And if interest rates rise you can very quickly wipe out that small term premium (10Y yield over cash yield).

      Like

  7. I can’t argue your facts. I’m still nervous though. I have backed off on my equity allocation. I think I’m just cheap and would prefer to buy stocks at a lower price. I realize this is more emotional than logical, but I have no need to take the risk and so I choose not to.

    Like

    • That “buying at a lower price” is a tough one. I feel that way too. If it’s any help, I’ve been feeling that ever since the S&P500 crossed 1200 points again after the global financial crisis. 🙂
      I just plow money in automatically to get over that!

      Like

  8. It’s definitely about time in the market and not timing the market. If stock prices fall this would be my first experience of a bear market so I don’t know what it feels like to go through. I just need to remember I’m in it for the long term.

    Like

  9. Fascinating reading about the EPS stuff / impact on CAPE – by removing the 2008-2009 and projecting for much higher EPS in 2018/19, CAPE moves quite a bit. Wow!

    I was also struck this week with another post I read over at “Of Dollars and Data”
    https://ofdollarsanddata.com/beyond-all-expectations-e93b358eb4f1

    The plot where he showed that CAPE is less meaningful for future returns when looked at through the lens of a longer time period (30yrs vs 5yrs) was also a big learning for me.

    All good stuff!

    Liked by 1 person

    • Thanks, Dr. PIE! Hadn’t seen the other site, thanks for the link! Of course, in defense of the CAPE I’d have to point out that for safe withdrawal rates, it’s the return over the first 10Y, not so much the return over the entire 30Y. So, folks closer to retirement still have a reason to be nervous.
      But for long-term investors just starting out saving for retirement? Fuggeddabout the CAPE! 🙂
      Cheers!

      Like

  10. Thanks for the work on this. Personally I focused on #3, and to me this feels like an Equity Risk Premium type of measure. I’m a financial economist at heart, and so this way of thinking makes sense to me. I like to believe there is some internal consistency between equity and bond pricing, and equity investors will get rewarded for taking on the extra risk. So confirmation here that the “ERP” is around 2%, is low, but not outrageously poor compensation for taking the additional risks of stocks over bonds.

    But I’m not as close to ER as you are. So I am pretty relaxed about SORR at the moment….

    Liked by 1 person

    • The ERP does look a little compressed at this moment (somewhere in the 200 – 300 bps range is my estimate), but nobody really knows.

      I personally will be taking a hard look at making extra payments towards the mortgage if tax reform passes. Maybe something like 25% or so of our monthly savings until the market looks more attractive. A 3.5% after tax risk free return looks pretty good in this environment.

      Liked by 2 people

      • Good point! I agree. The mortgage interest deduction is toast! They can’t get rid of it all at once. First, raise the standard deduction, so only very few people will itemize. Then get rid of the mortgage deduction completely. In a few years when only a few people will miss it. Very sneaky!
        So, paying down the mortgage doesn’t look like a bad financial decision. I certainly wouldn’t want to have a mortgage in retirement, see SWR series, part 21. 🙂

        Like

  11. Thank you for doing this. A lot of people are saying the markets are too high, but ‘too high’ compared to what? If EPS are equally ‘too high’ then the market bubble isn’t growing, it’s staying the same.

    I like your prediction analysis. I didn’t know how low the EPS numbers were 10 years ago – wow, how things have changed. As the low EPS numbers fall off and get replaced with high EPS numbers, it doesn’t look like the CAPE will spike.

    Liked by 1 person

    • Thanks! Yes, the earnings recession in 2008/9 was one of the worst ever! Of course, if the S&P keeps going up at 20% p.a. the CAPE will continue to rise, but with some decent moderate returns we should see some slow deflation of the CAPE soon!
      Cheers!

      Like

  12. Hi Big ERN. Something I’ve wondered about re SoRR, looking forward to your thoughts:

    Does ‘the first few years of retirement’ (or is it the first 5-10 years?) window depend on when one retires? I mean if you have a 60 year retirement and I have a 30 year retirement, is the concept of SoRR the same for both of us? Are we both golden if the markets don’t tank in the first few years after we each retire? Or does someone with a longer retirement have more (a longer?) SoRR somehow? Along the same vein, if one or both of us decided to work a few more years and the markets did well during that time, are we still as vulnerable to SoRR when we finally do retire? Didn’t we just work thru what would have been the vulnerable years if we had retired as originally planned? Would we still be as vulnerable once we finally retired? And last question, is it correct that SoRR is the biggest threat in year one and then decreases in each subsequent year?
    Thanks for any help on understanding this.

    Liked by 1 person

    • Very good point. There is no fixed time frame for that. In fact, during the 1965-1982 episode, markets didn’t tank until 5Y into the retirement and the real pain ensued in 1973-1982 (=years 8 through 17). So, there’s no guarantee.

      In fact, in a hypothetical 60Y retirement, if after 30Y you still have “only” your initial principal (inflation-adjusted), not more not less, then potentially years 31-40 are very risky from a SoRR perspective.

      Cheers!

      Like

  13. I think the Case/Schiller is something to look at, but if you look at other S&P P/E ratio’s (e.g. forward earnings) is certainly less than that. Now the market is certainly expensive and we will have a bear market, but that will happen probably another 1/2 dozen times in my life time. I am not that worried. Of course I am nowhere close to FI.

    Liked by 1 person

  14. I love seeing this after our back and forth over the bad numbers rolling out of the CAPE.

    I dislike the 10 CAPE specifically right now because many of the financial losses in 2008-2009 were mark to market or in real estate and the subsequent “adjustments” (gains) were realized by private real estate investors or hedge funds.

    Liked by 1 person

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