With all the warnings about excessively high valuations investors have been getting from gurus and the financial media, it’s not a surprise that a frequent conversation I’ve been having with investors starts out something like this: I’ve got cash to invest, but the market is at such a high level I think I should wait for a market correction before putting it to work. What should I do?
To address that question, I begin by first noting that, while U.S. equity valuations are at historically high levels, this is neither the case for non-U.S. developed markets or emerging markets.
Their valuations are much lower, and with the risk-free rate at historically low levels, this makes their equities look relatively more attractive. For example, while the CAPE 10 ratio for the U.S. market currently is about 30, it’s about 18.5 for EAFE market equities (almost 40% lower), and only about 14 for emerging market equities.
Having established that valuations—and, therefore, expected returns—around the globe are quite different, I’ll briefly revisit some insights on why the high level of the CAPE 10 in the U.S. may not be signaling overvaluation.
To begin, the Shiller CAPE 10’s historical mean is 16.8. The data set goes back to 1880, and it includes economic eras in which the world looked much riskier.
For example, for a significant part of the period, there was neither a Federal Reserve to dampen economic volatility nor an SEC to protect investor interests. The presence of both organizations has helped make the world a safer place for investors, justifying a lower equity risk premium and, thus, higher valuations.
Another reason for the CAPE 10 to rise over time is that the U.S. has become a much wealthier country. As wealth increases, capital becomes less scarce. All else being equal, less scarce assets should become less expensive, resulting in higher valuations.
There’s also an issue related to accounting changes. In 2001, the Financial Accounting Standards Board (FASB) changed the rules regarding how goodwill is written off. Prior to 2001, GAAP required goodwill amounts to be amortized—deducted from earnings as an incremental noncash expense over a 40-year period. But in 2001, FAS 142 was introduced.
Since that time, companies have been required to annually test goodwill for impairment. If assets are no longer deemed to be worth the prices paid, companies must immediately write down goodwill. What’s more, the requirement for annual impairment testing doesn’t just apply to goodwill, but to all intangible assets, and, per FAS 144 (issued a few months later), all long-lived assets.
While these changes introduced more accurate accounting methods, it also created an inconsistency in earnings measurements. Present values look more expensive relative to past values than they actually are. The difference is quite dramatic; adjusting for the accounting change would put the CAPE 10 about 4 points lower.
Another reason not to rely on the long-term historical mean of the Shiller CAPE 10 as a yardstick is that far fewer companies pay dividends now than in the past.
For example, in their 2001 study, “Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?”, Eugene Fama and Kenneth French found that the firms paying cash dividends fell from 67% in 1978 to 21% in 1999. This has resulted in the dividend payout ratio on the S&P 500 dropping from an average of 52% from 1954 through 1995 to just 34% since then.
In theory, higher earnings retention should result in faster earnings growth as firms reinvest that retained capital. To make comparisons between the Shiller CAPE 10’s present and past values, any differences in payout ratios must be normalized. The adjustment between the 52% payout ratio (the average from 1954 through 1995) and the 34% payout ratio (the average since) corresponds to roughly a one-point difference on the Shiller CAPE 10.
A Question Of Liquidity
And there’s yet another reason the long-term mean of the CAPE 10 might be misleading.
Investors demand a premium for taking liquidity risk (less liquid investments tend to outperform more liquid investments). All else equal, investors prefer greater liquidity. Thus, they demand a risk premium to hold less liquid assets. Over time, the cost of liquidity, in the form of bid/offer spreads, has decreased.
There are several reasons for this, including the decimalization of stock prices and the provision of additional liquidity by high-frequency traders. In addition, commissions have collapsed in price.
We also need to consider implementation costs. The expense ratios of mutual funds and ETFs have come way down, allowing investors to retain a greater percentage of the returns the markets provide. That, too, justifies higher valuations.
With all of these considerations in mind, it’s logical for valuations to have drifted higher over time. Thus, higher valuations today might not signal overvaluation. As I mentioned earlier, the 137-year average of the CAPE 10 is 16.8. However, the ratio’s average since 1960 is quite a bit higher, at 19.9. And since 1980, it’s an even higher 21.7.
While the CAPE 10’s current level of about 30 still looks high, it no longer makes the market look quite as dramatically overvalued, especially if we make the aforementioned adjustments for the change in accounting rules (about 4 points) and for lower dividend payout ratios (about 1 point).
Subtract those adjustments from the current level of 30 and we get an “adjusted” CAPE 10 (making more of an apples-to-apples comparison) of 25—and that’s before considering other factors that were mentioned above but not assigned a point value. Even a CAPE 10 of 25 is only about 15% above the ratio’s average over the last 57 years.
There’s one more issue to consider.
Nothing Magical About The CAPE 10
In their classic 1934 book, “Security Analysis,” Benjamin Graham and David Dodd noted that traditionally reported price-earnings ratios can vary considerably, because earnings are strongly influenced by the business cycle. To control for cyclical effects, they recommended dividing price by a multiyear average of earnings, and suggested periods of five, seven or 10 years.
Then, in a 1988 paper, economists John Campbell and future Nobel Prize-winner Robert Shiller, using a 10-year average, concluded that a long-term average does provide information in terms of future returns. This gave further credibility to the concept, and led to the popular use of the CAPE 10 ratio.
However, as Graham and Dodd observed, there’s really nothing special about using the 10-year average. Other time horizons also provide information on future returns. With that in mind, I’ll analyze how changing the horizon can impact our view of the market’s valuation.
At the end of July 2017, the CAPE 10 (which includes the very bad and temporarily depressed earnings figures from 2008 and 2009) was about 30. However, the CAPE 8, which excludes 2008 and has just as much predictive power for future returns, was lower, at about 27. The CAPE 6, which excludes both 2008 and 2009, was even lower, at about 24.5. With the adjustments we have discussed, the market doesn’t look overvalued at all.
The bottom line is that, once all these issues are accounted for, U.S. equities no longer look so overvalued. Perhaps still highly valued, but not overvalued, especially in light of the current regime of negative real rates on riskless Treasury bills.
Now that we’ve addressed the part of the question that deals with overvaluation, we have to consider its other aspect: If you don’t invest now, how will you know when it’s safe?
Opportunity Cost Of Not Investing
If you go to the beach to ride the waves and you want to know if it’s safe, you simply look to the lifeguard stand. If the flag is green, it’s safe. If it’s red, it might be fun, but it’s too dangerous to take a chance.
For many investors today, the market looks dangerously high, especially in light of the geopolitical risks we are facing. So, they don’t want to buy, or they may even decide to sell. Here’s the problem: While the surfer can wait a day or two for the ocean to calm down, there is never a green flag that will let you know that it’s safe to invest.
You might think that’s the case (like investors did in the late 1990s), but it never truly is. Recall the litany of problems the markets have faced since the S&P 500 bottomed out on March 9, 2009. The green flag letting you know it was safe simply has never appeared; it has been red the entire time. The following research from Elm Partners offers some valuable insight into the question of whether investors should wait to buy because they believe valuations are high.
Looking back at 115 years of data, Elm asked: “During times when the market has been ‘expensive,’ what has been the average cost or benefit of waiting for a correction of 10% from the starting price level, rather than investing right away?” They defined “expensive” as the occasions when the stock market had a CAPE ratio more than one standard deviation above its historical average.
The authors of the article noted that, while the CAPE for the U.S. market is currently hovering around two standard deviations above average, there aren’t enough equivalent periods in the historical record to construct a statistically significant data analysis.
They then focused on a comparison over a three-year period, a length of time beyond which they felt an investor was unlikely to wait for the hoped-for correction.
Following are their key findings:
- From a given “expensive” starting point, there was a 56% probability that the market had a 10% correction within three years, waiting for which would result in about a 10% return benefit versus having invested right away.
- In the 44% of cases where the correction doesn’t happen, there’s an average opportunity cost of about 30%—much greater than the average benefit.
- Putting these together, the mean expected cost of waiting for a correction was about 8% versus investing right away.
The takeaway is this: Even if you believe the probability of a correction is high, it’s far from certain. And when the correction doesn’t happen, the expected opportunity cost of having waited is much greater than the expected benefit.
Elm offered the following explanations for why it thought the perception exists among investors that waiting for a correction is a good strategy …
“First, while a correction occurring is indeed more likely than not, investors may confuse the chance of a correction from peak-to-trough with the lower chance of a correction from a fixed price level. For example, the historical probability of a 10% correction happening any time during a 3-year window is 88%, significantly higher than the 56% occurrence of that correction from the market level at the start of the period. Second, the cost of waiting and not achieving the correction is a ‘hidden’ opportunity cost, and we humans have a well-documented bias to underweight opportunity costs relative to realized costs. Finally, investors may believe they can wait indefinitely for the correction to happen, but in practice few investors have that sort of staying power.”
Elm repeated the analysis with correction ranges from 1% to 10%, time horizons of one year and five years, and an alternate definition for what makes the market look “expensive” (waiting for a correction from times when the market was at an all-time high at the start of the period).
The firm found that “across all scenarios, there has been a material cost for waiting. The longer the horizon that you’d have been willing to wait for the correction to occur … the higher the average cost.”
Noted author Peter Bernstein provided this insight: “Even the most brilliant of mathematical geniuses will never be able to tell us what the future holds. In the end, what matters is the quality of our decisions in the face of uncertainty.”
And we certainly live in uncertain times. But that’s always the case. To help you stay disciplined, it’s important to keep in mind the market already reflects whatever concerns you may have.
Consider an approach in which you buy, hold and rebalance, because that is what the evidence demonstrates is the most likely way to achieve your goals.
Doing so in the face of so much uncertainty, when stress can lead to panicked selling—let alone not buying with available cash—is what makes being a successful investor so difficult, despite how simple the winning strategy is. The inability to control one’s emotions in the face of uncertainty is why so few investors earn market rates of return and thus fail to achieve their objectives.
This commentary originally appeared August 23 on ETF.com
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