What to Expect When Stock Market is Expensive
Last week, we discussed the importance of investing with a long-term perspective. This week, we will seek to address a common concern among US investors: what to expect from the stock market going forward, now that a nine-year bull market has driven up equity valuations.
To start, let’s look at how expensive the S&P 500 is today relative to its own history since 1950, using the cyclically adjusted price-to-earnings ratio (CAPE) which was developed by Nobel Laureate and Yale economist Robert Shiller. The CAPE ratio divides the S&P 500’s price level by the average of its constituent companies’ earnings over the past 10 years. We believe this provides a stable measure of earnings that is generally unaffected by business cycles. Therefore, changes in the CAPE are primarily driven by fluctuations in the S&P 500’s price, which makes it useful as a measure of valuation.
Over the 68 years since January 1950, the S&P 500 has had an average CAPE ratio of 18.7. As of June 2018, the CAPE is 32.1, placing today’s S&P 500 valuation in the top quartile of historical valuations since 1950.
Figure 1: Historical S&P 500 Valuations, 1950–2018
Source: Robert Shiller’s website
What does this mean for expected returns going forward? Financial theory suggests that returns are inversely related to valuations, so investors should expect lower returns when valuations are high. The S&P 500 has historically delivered an average return of 10% per year. Since today’s S&P 500 valuation is in the fourth quartile, theory suggests that it would be reasonable for investors to set a lower expectation for returns over the next few years.
To test this theory empirically, we looked at historical base rates, drawing on monthly returns and CAPE ratios for the S&P 500 back to 1950. We sorted the historical data into quartiles of starting CAPE valuations and used Monte Carlo simulations to estimate the distribution of expected S&P 500 returns within each quartile. By randomly sampling from the historical returns in each quartile, Monte Carlo simulations provide more realistic estimates of uncertainty than rolling average returns, which overlap and are correlated to one another.
Historical precedent from fourth-quartile starting valuations suggests that the S&P 500 may deliver a nominal annualized return somewhere between 0% and 17% over the next 10 years. As shown in Figure 2, the S&P 500's base rate of return from fourth-quartile starting valuations was 8%, lower than the long-term average of 10%. Those numbers are nominal, with inflation averaging 3.5% over the period.
Figure 2: Nominal Historical S&P 500 Returns by Quartile of Starting Valuation, 1950–2018
Sources: Robert Shiller’s website, S&P Dow Jones Indices, and Verdad analysis
There are three important takeaways from Figure 2. First, the wide range of expected outcomes (5th percentile to 95th percentile) within each quartile and time horizon means that starting valuations have limited use for market timing. Just because the S&P 500 is relatively expensive today does not mean that investors should exit this segment of the market entirely. The second point of Figure 2, however, is that starting valuations can be useful for setting reasonable expectations. Investors have generally earned higher returns when starting valuations were lower. Third, a long investment horizon can be a good remedy for uncertainty. Across all quartiles of starting valuations, the uncertainty around the median expected return is much lower over longer horizons. Starting from fourth-quartile valuations, investors in the S&P 500 are as likely to get an annualized return between -16% and 36% over the next year as they are to get an annualized return between 0% and 17% over the next 10 years.
Given this information, what might investors consider doing with their investment portfolios? Our research suggests that if lower valuations mean higher expected returns, then investors should expect to profit from a) allocating to small value stocks in the US and b) allocating to international regions where equity valuations are lower.
Small value stocks in the US have historically offered a 5% premium relative to the S&P 500. As shown in Figure 3 below, that 5% small value premium has generally been consistent across quartiles of starting valuations.
Figure 3: Median Expected Returns by Quartile of Starting Valuation, 1950–2018
Sources: Robert Shiller’s website, Ken French’s data library, S&P Dow Jones Indices, and Verdad analysis.
A second tool that investors can use to improve their expected returns is allocating to international regions where equity valuations are lower. As we discussed previously, international markets currently trade at lower multiples of EBITDA, sales, and book value than the US. Figure 4 below compares the US against major international markets on three different valuation metrics and ranks them by equally weighting each metric.
Figure 4: International Valuations, 2018
Sources: Capital IQ and Star Capital
In the face of high valuations among US large-cap stocks, we believe investors can improve their expected outcomes by increasing their allocations to small value stocks and international equities. While the S&P 500 may be expensive today by historical standards, there are cheaper segments of the equity market that we believe should provide higher expected returns in today’s market: small value stocks and international stocks.