No. of Recommendations: 41
I am curious about how others are looking at the current market valuation and how you are interpreting them.As a rule of thumb, the CAPE ratio tells you what average performance to expect over the next decade - so now one must expect low returns - but doesn't tell you when to move in and out of the market. With that said, some analysis can still be useful for making stock (or index) purchase decisions as follows.
The CAPE ratio, over its history for predicting S&P500 returns, has no statistically meaningful predictive power for one-year forward returns. However, there is also very little data for when CAPE was as high as 37. It only went over 37 once - in Nov 1998 - and by chance it lasted above 37 for
a couple of years. But surviving 2 years over a CAPE of 37 shouldn't be seen as typical - it it just a single observation. In 1929, the CAPE only reached as high as 32 before collapsing immediately. Upon extrapolating the entire data set back to 1871 shows that the more overvalued, the
shorter-lived the high valuation would be. So the CAPE of 37 today, is perhaps a more dire than it would seem from the 2-year continuing fortune of 1998 alone.
But what happened in the past should also not give you excessive confidence about the future
because the historical record is being extended on a continued basis especially given the limited samples of such high valuations. With only
one observation with CAPE climbing to 37, and the conclusion being that it lasts 2 years, maybe this time will last 6 years - and then people will view about 4 years as normal. Or it could collapse today.
The overvaluation is also confined to the S&P500, and doesn't apply at all to just about every index not involving the large-cap stocks (Russell 2000, mid caps, small caps, equal weight which de-emphasizes large cap so greatly that it as if they are not there). It is amazing, even astonishing, how few market commentators, analysis and Bloomberg interviewees cite this. The S&P600 (small cap) CAPE is now at about 27, which his
below its 30 average level of the last 20 years, and about equal to its average level of the last 40 years.
However there is a nice coincidence that is worth thinking about, or perhaps being glad for. In fact, as small caps historically have grown about 2% faster than large caps (nb: owing to changing margins, please track the sales growth rather than earnings growth when comparing indexes), the S&P600 historically has traded as a higher valuations than the S&P500. But relative to
its own CAPE average, the S&P600 is not at all overvalued as this chart shows:
https://substackcdn.com/image/fetch/f_auto,q_auto:...For background as to why the S&P600 is a better investment today than the S&P500, I posted this on the Index Investing board recently:
https://www.shrewdm.com/MB?pid=515672466Probably the most important chart, though, is in this other post. It shows an extremely strong correlation between (CAPE(large cap) / CAPE(small cap)) versus the
difference between large cap returns and small cap returns. The correlation is even stronger than when just looking at the CAPE versus forward 10-year returns for the individual index:
https://www.shrewdm.com/MB?pid=333824071Especially study this chart:
https://www.firstlinks.com.au/uploads/2024/am-fig4...In the above chart, at any random point in the past, the red line was at the centre of the cluster (by definition) - now it is on the extreme left. Starting from today, the central expectation (with a pretty strong correlation) is that the S&P600 small caps will outperform the S&P500 by 5% per year, on average, for a whole 10 years - and the correlation is really tight. Five percent is an outperformance that the most crème de la crème investors, assuming they have a habit of remaining fully invested (which most of the good ones do), can only dream to reach over a whole decade.
Now if you buy the S&P600 (small caps) or Russell 2000, the returns are so correlated that as far as I'm concerned, you can treat them as the same. In any case, do not get hung up on which to select. Just avoid the S&P500 (if you think one of the tech stocks isn't overpriced, such as Google, or another, just add that alone). In any case, I often quote S&P600 as the comparison to S&P500 because it has the least in common. Equal-weight is also the same, but the costs are a fraction higher (you have to trade, whilst with the S&P600 you pretty much just hold everything when managing the ETF), and the long-term value generation is about the same between small cap and equal-weight. The Nasdaq-equal-weight (QQQE) is ideal for the long-long-term as it
had (though different to 'will have') better long-term value generation, but it is also trading above its own average valuation so its advantage over S&P600
if selecting exclusively for the medium term (5-10 years) is more dubious. If not sure, combine QQQE and IJR calling the pros and cons a wash.
But you know, after studying everything above, there is a separate very nice coincidence. It happens to be that:
1. When buying an index or individual stock that is undervalued,
it typically takes around 5 years (albeit a large error margin) for the valuation delta (relative cheapness) to make its way into the multiple change (realised price performance). (This why buying value stocks, even if you are right, gives you almost no advantage over one or two years, other than random chance, but is also exactly what - and only what - allows you to have a long-term outperformance.)
2. The CAPE ratio also has reasonable predictive power
only over 7-10 years. What happens in 2 years has no relation to the CAPE, and even 4 years out the prediction is dubious.
Believe it or not, these 2 things can be used together. Thinking casually about overvaluation, you will be (along with battle-scars) aware that equities are typically so highly correlated in the short-term (recall your past experiences when there is a rapid market decline) that
if there is a collapse in the S&P500, then everything gets taken down with it. So that may understandably lead you to feel anxious about your holdings today, regardless as to what you hold.
However, consider the above points (1 and 2) combined. Even if you expect a market decline, you shouldn't be too confident about when it will occur - statistically CAPE tells you little about what will happen in the next 3-5 years. And by chance these 3-5 years are also about the time it takes for disparate valuation multiples to correct on average.
That means that you don't have much reason to feel uncomfortable about holding the the S&P600
even aware that in the short-term it is highly correlated to the S&P500, because the
average expected return for the S&P500 over 5 years isn't terrible (it is only pretty bad looking out 7-10) years),
and the S&P500 is expected to outperform the S&P500 by 5% per year over the next 5 years. The concepts work really well in combination.
Having said
all of that, the 37 CAPE
so high for the S&P500 that, even still, now is a good time to be less aggressive than usual (more defensive). That is different for different people - for example, if you customarily use a little margin leverage, regardless of what equities you own, now is a good time to sell to pay some of the debt down.
Please continue this thread at the Index Investing board because it really isn't related to Berkshire Hathaway.
- Manlobbi
