A new way to value the market: The "fair-value" CAPE

27 March 2018 | Topical insights


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Are equities overvalued or undervalued? And what is a reasonable return expectation over the next decade? In any market environment, these questions are a topic of debate. Vanguard Investment Strategy Group has developed a new gauge that aims to provide a more accurate and useful answer.

Past improvements in the predictive power of the P/E ratio

Empirical evidence has shown that short-term equity market forecasting is a perilous undertaking. However, some valuation indicators, and the traditional price/earnings (P/E) ratio in particular, have shown a modest historical ability to forecast long-run returns.

In the late 1990s, professors Robert Shiller and John Campbell proposed an adjustment to improve the traditional P/E ratio's predictive power. Instead of dividing a market's current stock price by the average earnings per share generated over the prior four quarters, they divided it by the average inflation-adjusted earnings per share generated over the prior ten years. That modification captures the earnings power of the market over a business cycle better than a single year of earnings does.

As the figure below illustrates, the Shiller CAPE (cyclically adjusted price-to-earnings) ratio provided a fairly accurate forecast of 10-year-ahead returns – for a while. Since the mid-1990s, however, the predictive power of this metric has deteriorated. Contrary to expectations, the ratio has failed to revert to its long-term average for long periods. As a result, the metric has projected lower returns than those actually produced by the market. The notable absence of a reversion toward the Shiller CAPE's long-run average has raised doubts about its continuing usefulness in forecasting stock returns in real time.

Another step forward for forecasting: Vanguard's "fair-value" approach

Vanguard Investment Strategy Group's "fair-value" CAPE approach started with an observation: A long-term decline in interest rates and inflation depresses the discount rates used in asset-pricing models. The upshot is that investors are willing to pay a higher price for future earnings, thus inflating P/E ratios. The critical implication is that there is no reason for the CAPE ratio to revert to its long-term average. Instead, it should be expected to revert to a level that reflects current economic conditions.

To test our hypothesis, which breaks with the standard assumption that the CAPE will mechanically revert to its fixed long-run average, we used real interest rates, expected inflation and measures of financial volatility as proxies for the state of the economy to arrive at a "fair value" for the CAPE ratio.

More about our methodology and calculations can be found in our paper "Improving U.S. Stock Return Forecasts: A 'Fair-Value' CAPE Approach", published in the Winter 2018 issue of The Journal of Portfolio Management. The results in the chart below strongly suggest that adjusting the "long-term average" P/E ratio to account for macroeconomic conditions results in more accurate real-time projections of actual 10-year-ahead returns.

The fair-value CAPE has proved better at forecasting 1970 through 2016

CAPE forecasting chart

Notes: For the real-time analysis, the regression coefficients are determined recursively, starting with 10-year trailing annualised returns from January 1901–December 1959 data and re-estimating the regression coefficients with the addition of data for each month thereafter. Past performance is not a reliable indicator of future results.

Source: Davis, Joseph, Roger Aliaga-Díaz, Harshdeep Ahluwalia, and Ravi Tolani, 2018. Improving U.S. Stock Return Forecasts: A "Fair-Value" CAPE Approach. The Journal of Portfolio Management 44 (3): 43–55. © 2018 Institutional Investors LLC. All rights reserved.

It's worth noting that our fair-value CAPE would appear to explain both elevated CAPE ratios and robust equity returns over the past two decades.

What the different measures tell us now

At the end of 2017, the Shiller CAPE was flirting with all-time highs, surpassed only by the peaks that preceded the collapse of the dot-com bubble. It stood at about 33; its historical average is about 16. A reversion to the ratio's long-term average would bode ill for future equity returns.

Vanguard's fair-value CAPE ratio paints a less alarming picture. It suggests that valuations are indeed high but not in the "bubble" territory implied by the conventional CAPE. We expect the returns of US shares to fall below their historical averages over the next ten years. The most likely outcome, according to our projections, is annualised returns of 3%–5% for the coming decade.

That outlook is subdued, but not nearly as bleak as those suggested by tools that fail to account for today's low interest rates and inflation.

Investment risk information:

Past performance is not a reliable indicator of future results.

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Other important information:

This document is directed at professional investors only and should not be distributed to, or relied upon by, retail investors. It is designed for use by, and is directed only at, persons resident in the UK.

Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

This article was produced by The Vanguard Group, Inc. It is not a recommendation or solicitation to buy or sell investments.

The opinions expressed in this article are those of the individual authors and may not be representative of Vanguard Asset Management, Ltd.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.


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