A host of industry articles have recently raised an alarm about a possible return of irrational exuberance in the stock market, much like the one at the end of the 1990s. Bloomberg reports that investors have poured the most money into stock funds in 13 years:
Stock funds won $172 billion in the year’s first 10 months, the largest amount since they got $272 billion in all of 2000, according to Morningstar Inc. (MORN) estimates. Even with most of the cash going to international funds, domestic equity deposits are the highest since 2004.
In addition, investors currently have a high proportion of stocks in their portfolios:
The market run-up has left investors as a group with an unusually high allocation to equities, at 57 percent. Equity allocations were higher only twice in the past 20 years: in the late 1990s leading up to the technology stock crash of 2000, and prior to the 2007-2009 global financial crisis.
The most often quoted signal of overvaluation is Robert Shiller’s cyclically-adjusted price-to-earnings ratio (CAPE).
The numerator of the ratio is the real value of the S&P 500® index, i.e. a nominal value adjusted for inflation by the consumer price index (CPI). The purpose of this adjustment is to bring the value of the index to an equivalent present level. Assuming a rising CPI, i.e. inflation as opposed to deflation, historical values of the index are adjusted upwards. The intuition for this adjustment is that the nominal return of the index can be modeled as a sum of the real return and inflation. In the presence of inflation, the real return is smaller than the nominal one, hence a higher adjusted historical value of the index.
Similarly, the denominator of the ratio is a 10-year average of real trailing earnings of the index. A longer-term average removes the effects of market cycles. Nominal historical earnings are adjusted for inflation the same way as the index value.
The result is that, as reported by a Wall Street Journal article, the current CAPE of 25.2 is well above its historical average of 16.5:
Most industry articles therefore conclude that the market is in a bubble (although perhaps not as bad as in early 2000 when the CAPE was approximately twice as high). However, as the chart shows, the CAPE is currently still well inside the “yellow zone” and not in the “red zone” of 28.8 or higher.
Moreover, the current CAPE value in the chart is just an estimate. As of this writing, the actual data used to calculate the metric are incomplete. The most recent trailing four months of earnings (July through October) are missing and thus their adjusted counterparts are not included in the historical average. The November CPI is estimated from the values of just two previous months that indicated deflation.
When the missing earnings are estimated from the previous 12-month trend, the CAPE comes out closer to 24.8. The current 10-year earnings average starts in November 2003 when real profits were just rebounding from the nadir in March 2002. Therefore, in the next few years the denominator of CAPE should get larger. It is also worth noting that even with the current incomplete data, the CAPE was as high as 23.5 in February 2011, which at that time did not seem to raise many concerns.
In an interview with BusinessInsider in January 2013, Shiller stated the following:
John Campbell, who’s now a professor at Harvard, and I presented our findings first to the Federal Reserve Board in 1996, and we had a regression, showing how the P/E ratio predicts returns. And we had scatter diagrams, showing 10-year subsequent returns against the CAPE, what we call the cyclically adjusted price earnings ratio. And that had a pretty good fit. So I think the bottom line that we were giving – and maybe we didn’t stress or emphasize it enough – was that it’s continual. It’s not a timing mechanism, it doesn’t tell you – and I had the same mistake in my mind, to some extent. Wait until it goes all the way down to a P/E of 7, or something.
…the lesson there is that if you combine that with a good market diversification algorithm, the important thing is that you never get completely in or completely out of stocks. The lower CAPE is, as it gradually gets lower, you gradually move more and more in. So taking that lesson now, CAPE is high, but it’s not super high. I think it looks like stocks should be a substantial part of a portfolio.
I think predicting something like 4 percent real for the stock market, as opposed to 7 or 8 percent historically.
So, the CAPE should not be used as a timing mechanism but rather as an estimator of the future 10-year real returns. Even with the market reaching new highs, perhaps some rational exuberance is due after all.