1) If the EPS growth rate is higher but dividend yield has been lowered a corresponding amount, then aren’t expected returns unchanged?
2) If you make the adjustment you propose, is that enough to show normal valuations? My understanding is that according to Shiller PE valuations are about 2x historical norms.
3) Also, there’s many other alternative valuation models that currently give similar results to Shiller PE e.g. P/R, Tobins Q ratio, P/E with normalized profit margins.
4) These models are all correlated ~0.8 with 10yr returns, so you’d need to think something pretty substantial had changed for them to break down. [1yr forward P/E, by contrast, has much less correlation with long-run returns]
1) Yes but the Shiller PE will be higher, thereby (incorrectly) reducing its estimate of forward returns.
2) No, I agree the market is at above average valuation, just less extremely so than shiller PE would suggest. Though it looks cheap on Equity Risk Premium measures.
3) Yeah my objection is to the methodology not the conclusion. However I think many of those other methodologies are silly as well; for example, P/R does not make sense from an accounting standpoint (it should be EV/R). Changes in the structure of the economy have made book value metrics less relevant than historically, but I agree they are somewhat concerning.
4) Looking at historical correlations with returns introduces lookahead bias. If the market valuation doubled from here, and then remained flat for 100 years while earnings grew at their historic rate, schiller PE would remain correlated with returns, except it would retrospectively advise us to buy here.
Also, I’m having trouble replicating your numbers. Using the schiller data, I get correlations of −0.54 for CAPE vs 10yr return (real or nominal), and −0.49, −0.47 for PE vs 10yr return (real and nominal respectively). This is a small enough difference that we should prefer to use the more theoretically justified measure.
Also forward earnings estimates are not available that far back so I am sceptical of any research into their ability to forecast long-run returns! For 1-year holding periods they do about as well as trailing earnings though.
However, if we use a lookahead bias free measure, and instead of using the absolute level of PE / CAPE, we instead use the percentile of that metric, relative to its own history, the results basically reverse. Using this better measure I get −0.54 and −0.51 for PE vs −0.48 and −0.43 for CAPE. (in both cases I started the correlation in 1900 so we had a few decades of data for the percentiles to stabilize in.)
Interesting. My worry with credit-spread metrics is no-one cared about them pre-2008, so their performance is all in-sample basically. People always add new explanatory variables that explain the last crisis. However I am not an expert on this.
Very interesting. For the correlations I was just going with Hussman’s analysis. I know it’s simple, but it’s the best I’m aware of.
This post has a summary of a couple of methods which he says have 84% correlation with long-run returns, and currently predict returns of just a couple of percent for the next decade.
Philosophical economics has a some critical discussion of this and similar graphs, e.g. here and more directly here. There is also a lot of discussion of current elevation of profit margins and CAPE, which I found useful.
Larks, could you explain a bit more?
1) If the EPS growth rate is higher but dividend yield has been lowered a corresponding amount, then aren’t expected returns unchanged?
2) If you make the adjustment you propose, is that enough to show normal valuations? My understanding is that according to Shiller PE valuations are about 2x historical norms.
3) Also, there’s many other alternative valuation models that currently give similar results to Shiller PE e.g. P/R, Tobins Q ratio, P/E with normalized profit margins.
4) These models are all correlated ~0.8 with 10yr returns, so you’d need to think something pretty substantial had changed for them to break down. [1yr forward P/E, by contrast, has much less correlation with long-run returns]
1) Yes but the Shiller PE will be higher, thereby (incorrectly) reducing its estimate of forward returns.
2) No, I agree the market is at above average valuation, just less extremely so than shiller PE would suggest. Though it looks cheap on Equity Risk Premium measures.
3) Yeah my objection is to the methodology not the conclusion. However I think many of those other methodologies are silly as well; for example, P/R does not make sense from an accounting standpoint (it should be EV/R). Changes in the structure of the economy have made book value metrics less relevant than historically, but I agree they are somewhat concerning.
4) Looking at historical correlations with returns introduces lookahead bias. If the market valuation doubled from here, and then remained flat for 100 years while earnings grew at their historic rate, schiller PE would remain correlated with returns, except it would retrospectively advise us to buy here.
Also, I’m having trouble replicating your numbers. Using the schiller data, I get correlations of −0.54 for CAPE vs 10yr return (real or nominal), and −0.49, −0.47 for PE vs 10yr return (real and nominal respectively). This is a small enough difference that we should prefer to use the more theoretically justified measure.
Also forward earnings estimates are not available that far back so I am sceptical of any research into their ability to forecast long-run returns! For 1-year holding periods they do about as well as trailing earnings though.
However, if we use a lookahead bias free measure, and instead of using the absolute level of PE / CAPE, we instead use the percentile of that metric, relative to its own history, the results basically reverse. Using this better measure I get −0.54 and −0.51 for PE vs −0.48 and −0.43 for CAPE. (in both cases I started the correlation in 1900 so we had a few decades of data for the percentiles to stabilize in.)
I will send you the excel spreadsheet.
Also see this for a summary of the ‘risk-aversion’ measure:
http://www.hussmanfunds.com/wmc/wmc150413.htm
Interesting. My worry with credit-spread metrics is no-one cared about them pre-2008, so their performance is all in-sample basically. People always add new explanatory variables that explain the last crisis. However I am not an expert on this.
Very interesting. For the correlations I was just going with Hussman’s analysis. I know it’s simple, but it’s the best I’m aware of.
This post has a summary of a couple of methods which he says have 84% correlation with long-run returns, and currently predict returns of just a couple of percent for the next decade.
http://www.hussmanfunds.com/wmc/wmc130318.htm
Why do these disagree with your figures?
Philosophical economics has a some critical discussion of this and similar graphs, e.g. here and more directly here. There is also a lot of discussion of current elevation of profit margins and CAPE, which I found useful.
Thanks, that looks like a great blog.
Not sure. Did you get the excel sheet I sent?