The S&P 500 is currently experiencing a huge bull market, but it’s now clearly expensive on long-term valuation metrics like Robert Shiller’s CAPE. When I last looked the S&P 500 was up to 1,980, and at that level it has a CAPE ratio of 26.
That may not sound very interesting, but the S&P 500’s CAPE ratio has averaged just 16.5 over the last hundred years which, if I were to be sensationalist about it, would mean that the S&P 500 is more than 57% overvalued.
A statement like that is enough to strike fear into the heart of many a value investor, or cause much rolling of eyes from sceptics, bulls and growth investors.
The problem is it sounds so definite: 57% overvalued. It makes it seem like the S&P 500 is about to drop back to fair value at any minute, which would mean the index dropping all the way back down to 1,253. That’s a decline of almost 40%!
I don’t think statements like “57% overvalued” are helpful, but on the other hand I’m not saying that the S&P 500 isn’t expensive, because it is. However, there are better ways of getting the message across, such as:
The S&P 500 is expensive but that doesn’t mean it can’t keep going up
The S&P 500 is in the midst of a massive low volatility bull market. It’s quite spectacular as you can see:
Since clearing the old “resistance” around 1,500 in January 2013 the index has shot up by almost 30% in just 18 months or so.
Volatility has also been low and getting lower, producing high returns with little “risk”; what more could investors want?
The thing about bull markets is that they produce positive feedback. As shares go up investors think they’ll keep going up, so they buy more, which creates demand which drives up prices, and so on and so forth until there’s nobody left to buy.
So what’s gone up keeps going up, and that could easily be the case here. The peak CAPE value for the admittedly bonkers dot com boom was an eye watering 44, so perhaps there’s room for another 70% of upside yet, though I doubt it.
The S&P 500 is expensive which means that valuations are probably likely to contract in the longer-term
That’s not the sexiest sub-title in the world but it does represent a more reasonable and possibly more useful statement than “the S&P 500 is 57% overvalued”.
57% overvalued makes it sound like the market is destined to return to its long-term fair value, but in reality it isn’t.
We may never see the S&P 500’s CAPE at 16.5 again. Investing isn’t physics and there are no valuation “laws”. But we do have a lot of data going back over a long period of time and it would be foolish to just toss that in the bin.
So let’s have a look at what sort of values CAPE has had for the US large-cap index over the past century:
I’ve highlighted where it’s at today in black. Hopefully this makes the situation somewhat clearer. Rather than simply saying that the current valuation is 57% above the mean we can see what sort of range of CAPE values the S&P 500 has had over a 100 year period.
Amazingly enough the range goes all the way from less than 5 to more than 40; that’s quite a spread.
But within that spread it’s pretty obvious that the market spends most of its time with CAPE values somewhere between 5 and 30, and within that it spends most of its time in the 10-20 range.
I could also mention that while the mean CAPE value is 16.5 the median is lower at 15.4, which means the index has spent about 50 years out of the last 100 below 15.4; compare that to today’s level of 26. Or to belabour the point, the S&P 500 has spent 88% of its time with its CAPE value lower than it is today.
The S&P 500 is expensive, so future returns are likely to be below average
Of course what investors really care about are returns; valuations are just one way of uncovering companies and markets that may offer good risk adjusted returns.
So what does a CAPE valuation of 26 imply for future returns?
Let’s start with a few simple assumptions. Real growth of earnings has been close to 2% for the S&P 500 over the past century, so I’ll assume that will be the real rate of growth over the next decade. Inflation has averaged 3% during that time, so I’ll assume that going forward too.
Putting those together means that a reasonable ballpark assumption for the growth of average S&P 500 earnings over the next decade is 5% a year.
That would take the 10 year cyclically adjusted average earnings from 76 index points today to 123.7 index points in 2024 (i.e. if the S&P 500 is at 1,980 index points today and its CAPE is 26, then its cyclically adjusted earnings are 1,980 / 26 = 76).
If cyclically adjusted earnings are 123.7 index points in 2024 then what sort of values could the S&P 500 have at that time?
Again, it’s down to the assumptions that you make.
I prefer to make market projections over 10 years because over 10 years the relationship, or correlation, between today’s price and the price in 10 years is almost non-existent.
Because the two are not linked, and because we have no way of knowing what level the market will be at in a decade, a reasonable course of action is to assume that the likelihood of CAPE being at any particular level is the same as it was in the past.
For example we can just assume that the odds of the S&P 500’s CAPE being 17 in 2024 are the same as they have been in the last century. Of course the odds won’t be the same because history doesn’t repeat, but it does rhyme and so making forecasts and projections based on past data is a reasonable thing to do.
Taking all of those assumptions into account, the estimated odds of the S&P 500 having any particular value look like this:
So as you can see there is a tiny chance that the market will be below 618 in 2024, and some tiny chance that it will be above 4,948. The most likely of these various ranges is 1,237 to 1,855, where there is a 29% probability of the market being between those two values.
That’s not exactly encouraging and the chart suggests that there is a near 50% chance that the market could be lower in 2024 than it is today. That would be especially unpleasant given that the S&P 500 spent most of the previous decade failing to make new highs as well.
I’ve highlighted the range that contains today’s value of 1,980 and clearly there’s a good chance that the market could still be at that level 10 years from now.
None of this bodes particularly well for long-term investors of large-cap US stocks.
Of course if you’re optimistic then you could always argue that we’re in a long-term bull market and that there’s a 50% chance the market could be higher in 2024 than it is today.
You could even be really optimistic and say that there’s a chance the S&P 500 could reach 5,000 by 2024. But it’s a pretty small chance.