Stock market returns have been phenomenal over the last 10 years. The Real S&P Composite Total Return Index averaged 9.14% in the ten years since September 2008. The historical average of the Index since 1881 is just 6.48%. One might then wonder how likely these above-average returns are expected to continue. Academic studies by Fama-French and others have found a significant statistical relationship between long run security returns and ratios of market value relative to accounting-based measures of cash flow such as earnings, sales, and dividends.
One of those ratios is the Total Return Cyclically Adjusted Price-Earnings Ratio (TR CAPE) developed by Professor Robert Shiller (2014) at Yale University and defined as “the real total return per-share price divided by a long average of real scaled earnings per share, where the scaling of earnings takes into account the transition from price return to total return numbers” (p. 2). Much like the price-earnings (PE) ratio, the TR CAPE measures whether the current equity market value is high or low compared to its profit level. Unlike the PE ratio, it is adjusted for inflation, earnings volatility, and dividend policy. These adjustments smooth out measurement of earnings over an entire business cycle and provide a more meaningful metric. The chart below shows the TR CAPE (blue line) and Real S&P Composite Stock Price Index from January 1881 until September 2018 with important turning points labeled by year.
Source: Robert Shiller, Yale University. http://www.econ.yale.edu/~shiller/data.htm
As of September 2018, the TR CAPE of the S&P Composite Real Total Return Price Index is 36.15 which would place it 2.25 standard deviations above its historical average of 20.34 (1881-2008). Approximately 98.78% of all TR CAPE observations are expected to be less than or equal to the current level of 36.15 assuming a normal distribution. Historically, the TR CAPE was 36.15 or higher only three percent of the time. The data points to a TR CAPE that is well above average implying the aggregate US stock market may be overvalued. Historically high TR CAPE ratios have been found to be associated with a lower forward 10-year real return in the aggregate US stock market.
Source: NR Capital Management
Source: NR Capital Management
The regression model below shows the relationship between the natural log of TR CAPE and forward 10-year real returns (annualized) on the S&P Composite Real Total Return Price Index. TR CAPE was found to explain 32.12% of the variation in forward 10-year real returns with high confidence. The regression model predicts the average forward 10-year real return on the S&P Composite Real Total Return Price Index will be 1.01%. The 95% confidence interval ranges between -7.30% and 9.32%. Historically, the forward 10-year real return has been observed between -1.67% and 6.28% when the TR CAPE is between 30 and 40. These findings suggest the next ten years of aggregate US stock market returns are highly likely to be significantly less than the last ten years or the long-term historical average. Value-oriented strategies may outperform growth strategies over the next 10-15 years especially when TR CAPE mean reverts.
Source: NR Capital Management
Source: NR Capital Management Star Capital AG releases a monthly forecast of long-term expected real returns based on the Cyclically Adjusted Price-Earnings Ratio (CAPE) and Price-Book Ratio (PB). They forecast a 2.7% expected real return for the US stock market over the next 10-15 years which is below-average historically. Internationally, emerging markets may represent the best opportunity for growth with real returns expected to be approximately 7.6%. Developed Europe represents an opportunity for reasonable long-term growth with an expected real return of roughly 6.7%. Within developed Asia, Singapore, Hong Kong, and Australia are expected to earn 9.8%, 7.9%, and 6.3% real returns respectively. Japan has a mixed forecast with CAPE and PB forecasting 3.6% and 9.1% respectively.
