Most stock market forecasters have terrible track records (although they continue to make their predictions, with little to no accountability). However, one metric has been shown to offer some degree of predictive ability; the Shiller CAPE ratio.
The Shiller “cyclically adjusted price-to-earnings” ratio takes the current price of the stock market and divides it by the average stock market earnings over the past 10 years (adjusted for inflation). By averaging the earnings over 10 years, the effects of large earnings fluctuations in any given year are mitigated. A high relative value indicates an overpriced stock market, while a low figure indicates a bargain.
Vanguard recently produced a paper titled, Forecasting stock returns: What signals matter, and what do they say now? They found that valuation measures, such as the Shiller CAPE ratio, have shown some modest historical ability to forecast long-run returns. So what are these valuation metrics saying today?
The CAPE Crusader
Luckily for us, Raymond Kerzerho, Director of Research at PWL Capital, has come to the rescue. He has constructed Shiller CAPE ratios for some well-known stock market indices:
The Earnings Yield (E/P)
In order to estimate the real expected long-run return of the stock market, you will need to take the inverse of the Shiller CAPE ratio; this will give you the amount of real earnings you should expect for each dollar you invest. I also prefer to adjust this figure downwards by about 1% to account for earnings dilution (i.e. some of the earnings will go to owners and shareholders that do not yet exist).
Future Expected Portfolio Returns
If we assume inflation of 2% going forward, and nominal bond returns of 2.25%, what would be a reasonable return expectation for various Couch Potato asset allocations going forward?
Although these future returns could be better or worse than expected, this framework can be used to construct appropriate asset allocations that would be expected to meet the investor’s individual financial goals (stay tuned for my next post on this topic). As always, investors should never increase the risk of their portfolio beyond their ability, willingness and need to take risk.