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!
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!
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!
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!