The cyclically-adjusted price-to-earnings ratio (a.k.a CAPE, P/E10, Shiller’s P/E) evaluates the average inflation-adjusted earnings for the S&P 500 over the previous 10 years. The long-term CAPE average is 16.5. Today’s CAPE is north of 27. And despite numerous detractors on its predictive value, P/E10 led directly to a Nobel Prize for its creator, Robert Shiller.
With 140 years of market data, CAPE ratios above 27 have only occurred in the months around 1929, 1999 and 2007. Equally worthy of note, the Nobel economist’s work accurately identified the bursting of the dot-com bubble (1999-2000) as well as the collapse of the financial system (2007-2008).
Unfortunately for those who might like to argue why Shiller’s valuation methodology is irrelevant in 2015, U.S. stock prices are expensive whether you compare them to trailing 12 month earnings, forward 12 month earnings (being revised in light of the energy sector), book value and cash flow. Granted, one can suggest that zero percent rate policy makes Shiller’s P/E impotent; heck, those ridiculously low yields across the curve may make every traditional valuation metric worthless. Still, the more probable set of circumstances is that a bear market in equities is not too far off and that traditional valuation still has at least a single seat at the NYSE.
Indeed, if global interest rates continue to decline, strong corporations may do the same thing that they have been doing for the past six years; that is, they may issue low rate investment grade debt and use the funds to repurchase shares of corporate stock. That activity boosts the “E” in company earnings. I still believe this activity will keep equities from dropping off a cliff in the shorter-term. If nothing else, it is largely responsible for keeping the heralded index range-bound for the better part of the last 10 weeks.
Looked at another way, why would CEOs commit capital to major projects or human resources right now? The strong dollar is killing exports, weaker foreign currencies are hurting profits, global deflation is hindering sales and volatile oil prices are increasing geopolitical risks. The “go-to” move of share buybacks may very well be the primary driver that keeps the S&P 500 from falling out of bed.
We should be cognizant, however, that stock buybacks for the S&P 500 are already approaching the record highs set in mid-2007. Is that a good thing? Or does it merely mask the declining sales and increasing debt of the companies that engage in the practice for too long?
On the other side of the coin is the reality that bear markets are inevitable. So I decided to conduct a little exercise. What if the S&P 500 fell an average bear market percentage drop from its 2093 perch? If you split the difference between the average bearish descent since 1926 (35%) and the median plunge since 1871 (38%), the S&P 500 would bottom out near 1330.
Let’s take that prospect a step further. The total return for the S&P 500 SPDR Trust (SPY) with dividends reinvested would come in around 17.5% for the first 14-plus years of the 21st century, representing an approximate compounded return of 1.2%. Of course, this would only occur if you had bought-n-held-hoped through all of the downturns — 2000-2002, 2007-2009, 2011, 2015.
It gets worse. A 17.5% total return (1.2% compounded) looks even meeker up against an investment grade bond fund like PIMCO Total Return (PTTDX). Assuming an absence of safe haven buying in the hypothetical bearish downturn and using just the performance numbers to date, the fund’s 160% since December 31, 1999 represents 7% annualized. That is for investment grade bonds, folks.
“But Gary,” you protest. “You’re speaking in hypothetical scenarios. The return for the S&P 500 SPDR Trust (SPY) so far is actually 4.5% at a total return of 85%.” Fair enough. My questions to dismiss the thought process, then, are: (1) Do you believe that bear markets have been removed from the stock investing landscape and, (2) If you do believe in 30%-plus erosion of capital, what is your plan to minimize the damage?
The way that I see it, central banks cannot eliminate the inevitability of recessions or bear markets. Moreover, I believe that we are closer to the next “common sense” recession than we are to extraordinary acceleration of the U.S economy. It follows that I have to prepare for the high likelihood of changes ahead.