Are We Close to CAPE Fear?

Way back in 1934, Benjamin Graham and David Dodd published a famous financial analysis tome called Security Analysis. They argued that one-year returns are too volatile to make any informed decision on the future of a firm’s stock price.

It was suggested that using data of five or even ten years to smooth the returns was a far better predictor of a security’s forward-looking price. If we then fast-forward to the 1980’s, “Stock Prices, Earnings and Expected Dividends” was published by John Campbell and Robert Shiller. They determined that “a long moving average of real earnings helps to forecast future real dividends” which are correlated with returns on equities. Shiller would eventually go on to use Graham and Dodd’s analysis as a way to value the stock market. Shiller and Campbell used market data from both estimated and actual earnings reports from the S&P index and found that the lower the CAPE (cyclically-adjusted price earnings), the higher the investors’ likely return from equities over the following 20 years.

Below is a graph of the CAPE over time and in relation to the current value of the S&P 500. As a point of reference, in the 20th century, the CAPE had an average value of 15.21 (Shiller, 2014). The rather disconcerting point is that as of the end of Q1 2019, the CAPE is double the long-term average.

Source: Online data from Robert Shiller,

Data as at May 2019

The graph below is a new version of Shiller’s CAPE which takes into consideration recent structural changes. As Shiller states on his webpage, “As of September 2018, I now also include an alternative version of CAPE that is somewhat different. As documented in Bunn & Shiller (2014) and Jivraj and Shiller (2017), changes in corporate payout policy (i. e. share repurchases rather than dividends have now become a dominant approach in the United States for cash distribution to shareholders) may affect the level of the CAPE ratio through changing the growth rate of earnings per share. This subsequently may affect the average of the real earnings per share used in the CAPE ratio. A total return CAPE corrects for this bias through reinvesting dividends into the price index and appropriately scaling the earnings per share.” This shows an even greater disparity between the long-term average and the current level.

Source: Online data from Robert Shiller,

Data as at September 2018

History has shown that when the CAPE is high, as it is now, it is suggested that buying equities when the stock market is expensive dampens subsequent returns. A review of current CAPE values in the US, developed ex-US, and emerging markets shows that greater relative value lies in the emerging market space. On the other hand, as CAPE is not a good predictor of short-term returns, returns from this current cycle can still be high; it’s impossible to predict the stock market return over the next 12 months based on valuation factors.

The last US recession ended in Q2 2009. The boom and bust, (better defined as expansion and contraction) business cycles of the U.S. economy averaged 38.7 months in expansion and 17.5 months in contraction between 1854 and 2009. According to the National Bureau of Economic Research, there were 33 business cycles between 1854 and 2009, with each full cycle lasting roughly 56 months on average. A recession from an economic standpoint consists of two consecutive quarters of negative GDP (Gross Domestic Product) growth. To put our current cycle in context, we are currently in month 119 (as of April 2019) of expansion.

If one combines the current degree and length of expansion in the US with an exceptionally high CAPE, it’s not a far leap to expect weaker growth for US markets over the medium term with the prospect of a recession being unsurprising from a historical standpoint. However, as we know, past events and performance are not necessarily predictive in nature.

Risk Warnings and Important Information

This article is for information purposes only and is not intended to be relied upon as a forecast, research or investment advice. The value of investments can fall as well as rise. You may not get back what you invest. Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a reliable indicator of future results.

Although the information is based on data which MASECO Asia considers reliable, MASECO Asia gives no assurance or guarantee that the information is accurate, current or complete and it should not be relied upon as such.

MASECO Asia Limited (CE# BHR224) is authorized and regulated by the Securities and Futures Commission of Hong Kong to carry out Type 9 Regulated Activities.

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