If valuation levels are correct. This isn’t anything new or complicated, investing
in stocks when they are overvalued will likely yield a lower return over the
long-run then when stocks are undervalued.
There are various levels to measure this. For this post I will look at Dr. Shiller’s Cyclically
Adjusted Price to Earnings ratio (CAPE).
This widely utilized methodology calculates the inflation adjusted price
of the S&P 500 divided by the prior 10-year mean of inflation-adjusted
earnings. In short, it is a measure of
long-term valuation.
So where are we now? These
CAPE charts indicate:
- We have a ways to go before we launch our next secular bull market (i.e. we are still in a secular bear market).
- CAPE moves in downtrends and uptrends, we are in a downtrend.
- Thus, CAPE should contract further (higher earnings combined with lower or stagnant equity price levels) before the next great long term buying opportunity presents itself.
Recently I read
a study, which highlights the strong correlation between CAPE and forward
equity returns – the longer the time horizon, the greater the
correlation. This is true not only in our market, but other markets
(developed and emerging, though less tight in emerging).
This doesn’t mean you should avoid stocks altogether, in
fact in the short-term CAPE isn’t reliable at all. I just think it’s
important to highlight the secular bear cycle we are in and that future will
probably present better long term buying opportunities for equities than right
now.
