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Price, Value & the CAPE’d Crusade

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Image via Outcome/The Blue Diamond Gallery

By Noah Solomon

Special to the Financial Independence Hub

According to Warren Buffett, “Price is what you pay. Value is what you get.”

The cyclically adjusted price-to-earnings ratio, commonly known as CAPE, is a valuation measure invented by Nobel Prize recipient Robert Shiller. It is calculated by taking the price of an index and dividing it by its average earnings over the past 10 years, adjusted for inflation. The ratio’s use of average earnings over the last decade helps to smooth out the impact of business cycles and other events and thus provides a better picture of a market’s sustainable earnings power.

The CAPE ratio is commonly used to gauge future returns over medium to long-term horizons. In theory, higher than average CAPE levels imply lower than average future returns, while their lower counterparts suggest that future returns will be relatively high.

In the following piece, I analyze historical data to determine if the CAPE ratio has been a useful predictor of future real (i.e., after inflation) returns. In my view, including real rather than nominal returns is appropriate given the recent resurgence of inflation. Investors must be mindful of inflation’s potential to erode a substantial portion of their portfolios’ purchasing power. Lastly, I comment on what investors can expect going forward given the current CAPE level.

The following table presents average real future returns following various CAPE ranges.

S&P 500 Index: Average Real Returns Sorted by CAPE Ratio (Jan. 1970 – Nov. 2022)

There has been an inverse relationship between CAPE ratios and future returns. When the CAPE ratio has been near the high end of its historical range, future returns have tended to be relatively low. Conversely, low CAPE ratios have tended to foreshadow higher returns. Whereas this relationship has not been statistically significant over shorter holding periods, it has been strong over the medium to long-term.

When CAPE ratios have been below their historical average of 21, annualized real returns over the subsequent five years have averaged 8.3%, as compared to only 3.3% when CAPE ratios have stood above this level. The corresponding numbers for 10 year holding periods have been 8.8% vs. 4.2%.

The difference in average returns cannot be understated. On a $10 million investment over 5 years, the difference in return equates to a real value of $14,922,900 vs. $11,754,768. Adding in the average inflation rate since 1970 of 4.04%, the corresponding nominal values have averaged $17,920,804 vs. $14,240,696.

Over ten-year holding periods, the average real values of a $10 million investment made when CAPE levels were below vs. above average were $23,290,712 and $15,137,096, respectively. After adding back the post-1970 average inflation levels of 4.04%, these figures rise to $33,533,809 and $22,140,747.

These differences, although significant, represent the divergence in average returns during times when CAPE ratios have been merely above or below average. As the table above demonstrates, the difference in returns following investments made in very low vs. very high CAPE environments has been far greater.

Explaining the Anomalous “Bump”: Where Behavior Confounds Theory

Although low CAPE levels have been associated with higher future returns, and vice versa, the relationship is far from perfect across different CAPE ranges. Specifically, there is an anomalous “bump” whereby future returns for the 20-25 CAPE range have been nearly as high or higher than those that have followed any other CAPE level.

My best guess is that this peculiarity relates to human psychology and behavior. Historically, when stocks have risen for an extended period following a bear market, investors have been increasingly willing to believe that “it’s different this time” and that the good times will continue indefinitely. At these times, FOMO (fear of missing out), greed, and momentum have taken center stage until valuations reached levels which all but guaranteed a catastrophe.

Greed, Fear, & Where we Stand Today

The above relationships are a powerful representation of investor psychology. Historically, when the crowd’s greed manifests in lofty stock valuations, future returns have tended to be anemic. On the other hand, when widespread skepticism and despondency have caused earnings to go on sale, above average returns have tended to ensue. Alternately stated, investors would be well-served to follow Buffett’s advice to be “fearful when others are greedy, and greedy when others are fearful.”

Recent market malaise notwithstanding, stocks remain overvalued by historical standards. Taking the most recent data available, the CAPE ratio currently stands at 27.42, which is 30% higher than its historical average since 1970. This CAPE level implies real annualized returns over the next five years of 3.6%, which is approximately 50% lower than the 6.9% average that has prevailed since 1970. Over the next ten years, the implied real rate of return is 4.3% as compared to a historical average of 6.6%.

When the Going Gets Tough, the Tough get Tactical and Seek Dividends

Over five decades spanning January 1970 to December 2019, the two worst periods for the S&P 500 Index were the 1970s and the 2000s. Continue Reading…

Diversified & Dynamic: 2023 Global Investment Outlook

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By Ian Riach, Franklin Templeton Canada

(Sponsor Content)

Investors may see key improvements in conditions in the capital markets and the wider economy in 2023 and beyond, according to the Capital Market Expectations (CMEs) from Franklin Templeton Canada. We presented our CMEs at Franklin Templeton’s Global Investment Outlook in Toronto on December 6.

We develop a proprietary set of CMEs annually, using top-down fundamental and quantitative research​. Using an outlook for the next seven to 10 years, we review the expected returns and risk of investable asset classes: equities, fixed income, alternatives and currencies.​ Our economic outlook and 10-year asset class forecasts are driven by macro expectations, current valuations and various asset class assumptions​. The CMEs are annualized 10-year return expectations, and they are intended to coincide with the average length of a business cycle and are aligned with the strategic planning horizon of many institutional investors.

Our process also considers long-term macroeconomic themes to complement the objectivity of our quantitative analysis. This year, we factored in three major themes:

Growth: We expect to see moderate growth in the next phase of the economic cycle, driven by advances in technology and increasing productivity. Demographics will likely be a slight headwind to growth as populations in developed markets age.

Inflation: Inflation is expected to remain slightly higher than the targets established by central banks over the medium term​​. Rising wages and energy prices are sticky aspects of inflation.​​

Fiscal and monetary policy: Central banks, including the Bank of Canada, will keep up their aggressive fight against high inflation​​. Not surprisingly, this will hamper economic growth. On the other hand, we expect fiscal policy by governments to remain accommodative. Fiscal policy can result in higher government debt, which can be inflationary.​​ But if government stimulus targets, say, capital projects such as infrastructure, then it can be beneficial to long-term growth. Policymakers are ​​walking a tightrope now.

Capital Market Expectations

With that background, here is a concise summary of our expectations over the next several years:

  1. The expected returns for fixed income assets, like bonds, have become more attractive. We also expect the recent volatility in fixed income markets to subside.​
  2. The returns of global equities are expected to revert to their longer-term averages and outperform bonds.​
  3. Stocks in Emerging Markets are expected to outperform developed market equities over the next seven to 10 years​.
  4. A diversified and dynamic approach to investing is the most likely path to achieving stable returns over the long run.​

The chart below sets out our range of expectations for key assets compared to historical averages:

Note that these return projections are higher than our 2022 outlook and are closer to their long-term averages.

Franklin Templeton Canada uses its CMEs to shape strategic asset allocation for our portfolios. However, we do not just “set it and forget it”.  We employ a dynamic asset allocation process over the shorter-term, taking into account market conditions. While we are optimistic over the next decade that returns will favour risk assets, our short-term preference (next 12 months) is to be cautious as recession risks rise. Continue Reading…

The Inevitable masquerading as the Unexpected

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By Michael J. Wiener

Special to the Financial Independence Hub

Rising interest rates are causing a lot of unhappiness among bond investors, heavily-indebted homeowners, real estate agents, and others who make their livings from home sales.  The exact nature of what is happening now was unpredictable, but the fact that interest rates would eventually rise was inevitable.

Long-Term Bonds

On the bond investing side, I was disappointed that so few prominent financial advisors saw the danger in long-term bonds back in 2020.  If all you do is follow historical bond returns, then the recent crash in long-term bonds looks like a black swan, a nasty surprise.  However, when 30-year Canadian government bond yields got down to 1.2%, it was obvious that they were a terrible investment if held to maturity. This made it inevitable that whoever was holding these hot potatoes when interest rates rose would get burned.  Owning long-term bonds at that time was crazy.

One might ask whether we could say the same thing about holding stocks in 2020 when interest rates were so low.  The answer is no.  Bond returns are very different from stock returns in terms of unpredictability.  We use bond prices to calculate bond yields; one is completely determined by the other.  The situation is very different with stocks.  Even when conditions don’t look good for stocks, they may still give better returns than the interest you’d get if you sold them to hold cash.  All the evidence says that most investors are better off not trying to time the stock market.

Most of the time, investors are better off not trying to time the bond market either.  However, the conditions in 2020 were extraordinary.  Long-term bonds were guaranteed to give unacceptably low returns if held to maturity.  This was a perfectly sensible time to shift long-term bonds to short-term bonds or cash savings.

Houses

The only way house prices could rise to the crazy heights they reached was with interest rates so low that mortgage payments remained barely affordable.  Fortunately, the government imposed a stress test that forced buyers to qualify for a mortgage based on payments higher than their actual payments.  This reduced the damage we’re starting to see now.  Unfortunately, there is evidence that some homeowners faked their income (with industry help) so they could qualify for a mortgage.  This offset some of the good the stress test did. Continue Reading…

Innovation is the key to growth

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By Erin Allen, CIM, VP Online ETF Distribution, BMO ETFs

(Sponsor Content)

It’s simple, innovation has the potential to create higher productivity: the same input generates higher output.  As productivity moves higher, more goods and services are produced, and as such the company or the economy grows.

Innovative companies in turn will displace industry incumbents as they see an increase in efficiencies and productivity leading them to gain market share. The long-term growth potential of these innovative companies is what investors in this space are after.

In the late nineteenth century, the introduction of the telephone, automobile, and electricity changed the way we communicated, travelled, transported, and powered our economy. The world’s productivity went through the roof as costs dropped, creating demand across sectors.

 Source: BMO ETFs, Nov 2022

Today, the global economy is undergoing a technological transformation that will shape the future. Innovations in areas such as artificial intelligence, robotics, DNA sequencing, energy storage and blockchain technologies are evolving at a rapid rate and seeing cost declines that are expected to further lead this growth.

BMO Global Asset Management offers three ETF series in partnership with ARK Invest that focus on disruptive innovations. BMO ARK Innovation Fund ETF Series (ARKK), BMO ARK Genomic Revolution Fund ETF Series (ARKG), and BMO ARK Next Generation Internet Fund ETF Series (ARKW).  ARK believes innovations should meet three criteria and invests accordingly in these unconstrained, high-conviction portfolios.

3 Criteria for Innovations

  1. Dramatic cost declines
  2. Cuts across sectors and geographies
  3. Serves as a platform for additional innovations.

For illustrative purposes only. Source: ARK Invest

Continue Reading…

Retired Money: Direct Indexing has drawbacks but a hybrid DIY strategy may have merits

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Image courtesy MoneySense.ca/Unsplash: Photo by Ruben Sukatendel

My latest MoneySense Retired Money column looks at a trendy new investing approach known as “Direct Indexing.” You can find the full column by clicking on the highlighted headline: What is direct indexing? Should you build your own index?

Here’s a definition from Investopedia : “Direct indexing is an approach to index investing that involves buying the individual stocks that make up an index, in the same weights as the index.”

When I first read about this, I thought this was some version of the common practice by Do-it-yourself investors who “skim” the major holdings of major indexes or ETFs, thereby avoiding any management fees associated with the ETFs. It is and it isn’t, and we explore this below.

Investopedia notes that in the past, buying all the stocks needed to replicate an index, especially large ones like the S&P 500, required hundreds of transactions: building an index one stock at a time is time-consuming and expensive if you’re paying full pop on trading commissions. However, zero-commission stock trading largely gets around this constraint, democratizing what was once the preserve of wealthy investors.   According to this article that ran in the summer at Charles River [a State Street company], direct indexing has taken off in the US: “ While direct index portfolios have been available for over 20 years, continued advancement of technology and structural industry changes have eliminated barriers to adoption, reduced cost, and created an environment conducive for the broader adoption of these types of strategies.”

These forces also means direct indexing can be attractive in Canada as well, it says. However, an October 2022 article in Canadian trade newspaper Investment Executive suggests “not everyone thinks it will take root in Canada.” It cast direct indexing as an alternative to owning ETFs or mutual funds, noting that players include Boston-based Fidelity Investments Inc, BlackRock Inc., Vanguard Group Inc., Charles Schwab and finance giants Goldman Sachs Inc. and Morgan Stanley.

An article at Morningstar Canada suggested direct indexing is “effectively … the updated version of separately managed accounts (SMA). As with direct indexing, SMAs were modified versions of mutual funds, except the funds were active rather than passive with SMAs.”

My MoneySense column quotes Wealth manager Matthew Ardrey, a vice president with Toronto-based TriDelta Financial, who is skeptical about the benefits of direct indexing: “While I always think it is good for an investor to be able to lower fees and increase flexibility in their portfolio management, I question just who this strategy is right for.” First, Ardrey addresses the fees issue: “Using the S&P500 as an example, an investor must track and trade 500 stocks to replicate this index. Though they could tax-loss-sell and otherwise tilt their allocation as they see fit, the cost of managing 500 stocks is very high: not necessarily in dollars, but in time.” It would be onerous to make 500 trades alone, especially if fractional shares are involved.

Ardrey concludes Direct indexing may be more useful for those trying to allocate to a particular sector of the market (like Canadian financials), where “a person would have to buy a lot less companies and make the trading worthwhile.”

A hybrid strategy used by DIY financial bloggers may be more doable

I would call this professional or advisor-mediated Direct Indexing and agree it seems to have severe drawbacks. However, that doesn’t mean savvy investors can’t implement their own custom approach to incorporate some of these ideas. Classic Direct Indexing seems similar but slightly different than a hybrid strategy many DIY Canadian financial bloggers have been using in recent years. They may target a particular stock index – like the S&P500 or TSX – and buy  most of the underlying stocks in similar proportions. Again, the rise of zero-commission investing and fractional share ownership has made this practical for ordinary retail investors. Continue Reading…