After an excellent year for stocks, many investors are wondering whether shares have gotten too expensive by now. Some analysts have cautioned that the continued rally has driven Prof. Robert Shiller’s cyclically adjusted real price-earnings ratio, known as CAPE, well above its 132-year average….
For professional investors and advisers only.This document is not suitable for retail
Mikio Kumada, Global Strategist at LGT Capital Management
However, history shows that this might just as well be a harbinger of a more normal and self-confident phase of a bull market that could well last for several more years.
Record levels often trigger valuation concerns
The S&P 500 marked a symbolic milestone on 10 April, when it rallied to close above its pre-crisis record of 2007 for the first time. The US stock market benchmark has gained another 14.9% since. Eurozone and Japanese stocks did even better, with the EuroStoxx and the Nikkei 225 surging by about 18%. At the same time, except for a few brief outbursts, volatility remained low and on a modestly declining path. These strong gains and potential signs of complacency lead many investors to worry about stock market valuations.
Stocks not as cheap as a few years ago
Based on consensus estimates for next year, the price-to-earnings and price-to-sales ratios (PE and PS) are still within reasonable levels, though in many cases not as attractive as during the first years of the bull market. The forward PEs now range from a low 7.7 for China to 14.8 for Switzerland. PS ratios range between 0.8 and 1.7, also for China and Switzerland, respectively (see page 4, in the PDF). The current ratios are close to their five to ten year averages in the US and Europe and well below those levels in China and Japan.
Some market participants are concerned about the long-term picture
However, some market participants are now pointing at the elevated CAPE ratio as a warning sign. This ratio, popularized by Professor Robert J. Shiller in his book “Irrational Exuberance” at the height of the New Economy euphoria in 2000, uses inflation-adjusted values and the ten-year average of corporate earnings to visualize the real structural trend, rather than the nominal cyclical one. It is currently about 52% above its historical average since 1881 (see chart 1, page 2 in the PDF).
Increased valuations are normal during a bull market
Nevertheless, it should be remembered that CAPE, while useful for very long-term investment decisions, is not a practical guide for the short- to medium-term. History shows that valuations can continue to rise and remain elevated for many years. In bull markets, rising and/or high PEs are ultimately primarily an expression of an increasingly positive investor sentiment – which is a very normal state of mind during an equity boom.
Possible harbinger of further stock markets in coming years
The problem mainly arises when the ratio moves closer toward extreme levels – such as those seen in the final stages of the great financial booms of 1920-1929 and 1982-1999, when the CAPE ratio surged sevenfold to more than double its respective historical norm at the time. But even such strong and (in retrospect) obvious stock market bubbles can last for years. Valuations can also stay elevated at comparatively moderate levels for a long time, without hurting returns. That was the case in 1894-1903 and in 1955-1973, when the stock market index rose by between half to double in real terms, respectively. The bull market norm is that rising or high valuations usually go hand in hand with positive real returns. Thus, today’s elevated CAPE shouldn’t be perceived as solely a potential warning sign. The bull market that began in March 2009 was mostly driven by a strong rebound in corporate earnings, and has been repeatedly questioned over the years, only to prove surprisingly stable in the end. The elevated CAPE could therefore just as well prove a harbinger of continued stock market gains in coming years. Consistent with past patterns, it may simply be signaling a more mature phase of the bull market – one that is driven by increasing investor recognition and optimism, rather than strong profit growth.
Source: ETFWorld – LGT Capital Management
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