Cape fear: US stock valuations exceed 1929 peak

A strong start to 2018 means US stock market valuations continue to head higher, so much so that the S&P 500 now appears to be even more expensive than it was prior to the infamous 1929 Wall Street crash. Is the US market as overvalued as it looks? If so, might a peak in equity markets be around the corner for investors?

The S&P 500’s cyclically adjusted price-earnings (Cape) ratio now stands at more than 32, just above that seen at the 1929 peak and almost twice as high as its long-term average. That makes the current market the second most-expensive in history.

The only time stocks have been more highly valued was in the late 1990s, at the height of the dotcom bubble.

A widely-followed indicator most associated with Nobel economist Robert Shiller, Cape averages earnings over a 10-year period, thereby smoothing out the effect of artificially high or low earnings seen at different stages of the business cycle. Some of the highest Cape readings in history were registered prior to major market crashes – famously, Shiller's book Irrational Exuberance was published in 2000, just before the technology bubble burst – and the indicator has long been used by long-term investors to establish whether equities are cheap or expensive.

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A broken indicator?

While some investors will be alarmed by the 1929 comparison, many others see Cape as a broken indicator, pointing out the US Cape ratio has been well above historical norms for almost all of the last 25 years.

Bullish commentators such as Prof Jeremy Siegel, a friend of Shiller's who has often sparred with him on the question of Cape's continued usefulness, argue that changes in accounting standards have artificially depressed earnings, thereby resulting in artificially high Cape readings.

Others say earnings were abnormally low in 2008-09 and that this continues to distort current readings. Some commentators – including Jeremy Grantham, the famous value investor who has long been wary of US equities on valuation grounds – suggest economic and technological developments have driven corporate profit margins to unprecedented levels and that high Cape readings partly reflect these changed structural forces.

Research Affiliates' Rob Arnott, another influential value investor who has long been concerned by high Cape readings, admits today's valuations are not quite as abnormal as they appear. Today's Cape may be twice historical norms, but the upward trend in Cape ratios over time makes sense, said Arnott in a new paper on the subject earlier this month. By modern standards, the US was an emerging market in the 19th century, so valuations "should rise as the US market matures and becomes more efficient".

‘Cape naysayers are wrong’

Nevertheless, while many commentators argue Cape needs to be tweaked to adjust for changing realities, such tweaks only lessen the level of overvaluation – they do not eliminate it. 2018 is not 1929, but stocks still look very pricey. Arnott's paper, Cape Fear: Why Cape Naysayers are Wrong, notes that four other widely used valuation metrics confirm US valuations have looked dangerously high for some time.

Furthermore, many of the arguments used to justify high Cape readings could also be applied to non-US markets, but almost all international markets are much cheaper than the S&P 500.

The valuation difference “has rarely been wider”, says Arnott. He asks: “Should we not question paying $32 for every $1 of earnings in the United States when Canada is trading at 20x earnings, Germany at 19x, and the United Kingdom at 14x, especially when these three markets are all trading near their respective historical Cape norm and the United States is not?”

This is echoed by Jeremy Grantham, who says investors should prioritise non-US markets, especially emerging markets. “The data on the high price of the market is clean and factual”, Grantham wrote in his first note of 2018. “We can be as certain as we ever get in stock market analysis that the current price is exceptionally high.”

However, even if one agrees with this analysis, it doesn’t follow that stocks must fall any time soon.

On the one hand, there is a well-established link between valuation and future long-term returns – low valuations tend to be followed by higher returns, high valuations by lower returns. However, there is, writes Ritholtz Wealth Management strategist and blogger Ben Carlson, "no threshold level that, once breached, gives investors a clear signal to get out". Stock prices can remain high for some time.

During the technology bubble, Robert Shiller first warned of “irrational exuberance” in 1996. By 1997, the Cape ratio exceeded 30 for the first time in history, but stocks went on to more than double before finally crashing in March 2000. Valuations dictate long-term returns but they “have never worked as a timing tool”, says Carlson. Over the short-to-intermediate term, stocks are driven by “sentiment, trends and momentum more than fundamentals”.

Sentiment

Right now, the momentum is with the bulls, but 2018 looks very different to 1929 in that sentiment is nowhere near the euphoric levels typically seen near market peaks.

Speculators and day traders are focused on cryptocurrencies, not stocks, and the absence of euphoria recently prompted Jeremy Grantham to say that stocks may gain over 50 per cent over the next six months to two years as the long bull market finally enters its “melt-up” phase. Stocks have risen in each of the last 13 months, but it has been a gradual rise rather than a feverish one, with the S&P 500 rising 27 per cent.

In contrast, notes money manager and Bloomberg columnist Barry Ritholtz, the average gain during the five previous times where stocks registered at least 10 consecutive monthly gains was 50 per cent or more. The S&P 500's single best day in 2017 was a rise of just 1.38 per cent.

The “slow gradual grind higher” and the lack of outsized single-day gains “should make us question claims of reckless purchases and a stock-market bubble”, says Ritholtz.

In other words, the idea that we are witnessing 1929-like excess just doesn’t hold up. Technically, the bull market continues to look robust, sentiment is not at bullish extremes and making modest adjustments to the Cape ratio lowers the level of overvaluation.

Nevertheless, Arnott says investors should be cautious. “No matter what adjustments we make, the US market is expensive”, says Arnott. “Investors ignore the warnings of high US Cape ratios at their peril”.