Inflation

Inflation

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…

Recession “most probable” scenario for US and Europe in 2023: Infrastructure plays attractive, says ClearBridge

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Image: Pexels/Engin Akyurt

’Tis the Season for economic forecasts. Further to the Vanguard 2023 outlook highlighted on the Hub yesterday comes various forecasts from Franklin Templeton Investments and its sub-advisors.

The selections below suggest Recession is the most likely scenario for 2023 — something Vanguard also forecast — and ClearBridge Investments sees Infrastructure assets as more promising than global equities during this period. Clearbridge runs the Franklin Clearbridge Sustainable Global Infrastructure Income Active ETF.  See also this blog on Infrastructure investing from BMO ETFs, which ran on the Hub late in August.

As with Monday’s blog, we’ve highlighted relevant paragraphs directly from the horse’s mouth, including the subheadings from the various money managers. Unless otherwise indicated, images are from our image banks.

ClearBridge Investments: U.S. economic outlook by Investment Strategist Jeff Schulze

Recession is the path of least resistance

As we look ahead to 2023, recession has gone from a distantly possible scenario to the most probable one, and the potential pivot by the Fed that many equity investors are hoping for is unlikely to occur.

Our views are grounded in the reading of the ClearBridge Recession Risk Dashboard of 12 economic indicators, which has been flashing red for the past four months, indicating a recession. Eight of the 12 underlying indicators are signaling recession, including traditional recession precursors, like the 10- year/3-month Treasury yield curve, which inverted this fall. This portion of the yield curve has correctly anticipated the last eight recessions dating back to 1970, providing an average of 11 months of warning.

Image: Pexels/Mart Production

A recession is not a done deal, however. The most likely positive path involves what we have dubbed the “immaculate slackening” where the labor market tightens but not too many jobs are lost. Job openings are still more than 3 million above their pre-pandemic level (but down 1.5 million from the peak), while the total number of persons employed is only around 1 million greater than before COVID-19. This suggests room exists to loosen labor demand but not destroy as many jobs, which would help restore balance and ease wage gains. Importantly, this could help ease inflation, particularly in service industries where wages are a larger component of prices.

The most important factor to achieve a soft landing is a substantial reduction in inflation, which would allow the Fed to back off its aggressive actions. With inflation unlikely to return to 2% in 2023, and the labor market proving resilient, the Fed is likely to continue to tighten monetary policy to slow the economy and curb price increases, which will ultimately result in a recession. Monitoring the health of the labor market will be important in the coming year, given its role as a key inflation barometer for the Fed. We will also be looking for signs of weakening consumption outside of the most interest rate sensitive areas as evidence that a slowdown is taking deeper root.

ClearBridge Investments: Global infrastructure outlook by Portfolio Managers Charles Hamieh, Shane Hurst and Nick Langley

Infrastructure earnings more secure than global equities; U.S. expected to focus on renewables

From no growth in 2020 to rapid growth in 2021 to slow growth in 2022, we look at 2023 with a base case of recessions in the U.S., Europe and the U.K.

The impact on infrastructure, though, should be muted, particularly for our regulated assets, where the companies generate their cash flows, earnings and dividends from their underlying asset bases, as we expect those asset bases to increase over the next several years. As a result, infrastructure earnings look better protected compared to global equities.

Infrastructure assets more secure than global equities. Image from Franklin ClearBridge

Most infrastructure companies have a link to inflation in their revenue or returns. Regulated assets, such as utilities, have their regulated allowed returns adjusted for changes in bond yields over time. As real yields rise, utilities look poised to perform well, and we have currently tilted our infrastructure portfolios to reflect this.

As a result, the underlying valuations of infrastructure assets are relatively unaffected by changes in inflation and bond yields. However, we have seen equity market volatility associated with higher bond yields impact the prices of listed infrastructure securities, making them more compelling when compared with unlisted infrastructure valuations in the private markets.

On top of its relative appeal versus equities, infrastructure should benefit from several macro drivers in 2023 — and beyond. First, energy security is driving policy right now, and a significant amount of infrastructure will need to be built to attain energy security. High gas prices and supply constraints brought on by the Russia/Ukraine war have highlighted the importance of energy security and energy investment. This is supportive of energy infrastructure, particularly in Europe, where additional capacity is needed to supplant Russian oil and gas supply, and in the U.S., where new basins are starting up, in part to meet fresh demand from Europe. Continue Reading…

Vanguard says Balanced portfolios still offer best chance of success as Inflation gets beaten back

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While the traditional 60/40 balanced portfolio has suffered its worst year in decades, and Recession is likely in 2023, the Vanguard Group is optimistic that balanced portfolios will thrive beyond 2023 and over the rest of the decade.

“A balanced portfolio still offers the best chance of success,” is one of the top conclusions that will be unveiled Monday:  Vanguard Canada is hosting its Economic and Market Outlook for 2023, with a global virtual press conference scheduled at 11 AM [Dec. 12].  It includes Vanguard economists such as Global Chief Economist Joe Davis.

Below, received last week under embargo, are highlights of a report titled Vanguard Economic and Market Outlook for 2023: Beating back inflation. It runs about 60 pages, including numerous charts.

The text below consists mostly of excerpts from the Vanguard report, with the use of an ellipsis to indicate excisions, so there are no passages in quotation marks. Subheads are also taken from the original document. Apart from a handful of charts reproduced below, references to numerous other charts or graphs have been removed in the excerpts selected below.

Base case for 2023 is Disinflation

Our base case for 2023 is one of disinflation, but at a cost of a global recession. Inflation has likely already peaked in most markets, but reducing price pressures tied to labor markets and wage growth will take longer. As such, central banks may reasonably achieve their 2% inflation targets only in 2024 or 2025.

Consistent with our investment outlook for 2022, which focused on the need for higher short-term interest rates, central banks will continue their aggressive tightening cycle into early 2023 before pausing as inflation falls. As such, our base case has government bond yields generally peaking in 2023. Although rising interest rates have created near-term pain for investors, higher starting rates have raised our return expectations for U.S. and international bonds. We now expect U.S. and international bonds to return 4%–5% over the next decade.

Equity markets have yet to drop materially below their fair-value range, which they have historically done during recessions. Longer term, however, our global equity outlook is improving because of lower valuations and higher interest rates. Our return expectations are 2.25 percentage points higher than last year. From a U.S. dollar investor’s perspective, our Vanguard Capital Markets Model projects higher 10-year annualized returns for non-U.S. developed markets (7.2%–9.2%) and emerging markets (7%–9%) than for U.S. markets (4.7%–6.7%).

Global inflation: Persistently surprising

Our base case is a global recession in 2023 brought about by the efforts to return inflation to target … growth is likely to end 2023 flat or slightly negative in most major economies outside of China. Unemployment is likely to rise over the year but nowhere near as high as during the 2008 and 2020 downturns. Through job losses and slowing consumer demand, a downtrend in inflation is likely to persist through 2023. We don’t believe that central banks will achieve their targets of 2% inflation in 2023, but they will maintain those targets and look to achieve them through 2024 and into 2025 — or reassess them when the time is right. That time isn’t now.

Global fixed income: Brighter days ahead

The market, which was initially slow to price higher interest rates to fight elevated and persistent inflation, now believes that most central banks will have to go well past their neutral policy rates — the rate at which policy would be considered neither accommodative nor restrictive — to quell inflation.

Rising interest rates and higher interest rate expectations have lowered bond returns in 2022, creating near-term pain for investors. However the bright side of higher rates is higher interest payments. These have led our return expectations for U.S. and international bonds to increase by more than twofold. We now expect U.S. bonds to return 4.1%–5.1% per year over the next decade, compared with the 1.4%–2.4% annual returns we forecast a year ago. For international bonds, we expect returns of 4%–5% per year over the next decade, compared with our year-ago forecast of 1.3%–2.3% per year.

Global equities: Resetting expectations

The silver lining is that this year’s bear market has improved our outlook for global equities, though our Vanguard Capital Markets Model (VCMM) projections suggest there are greater opportunities outside the United States.

Stretched valuations in the U.S. equity market in 2021 were unsustainable, and our fair-value framework suggests they still don’t reflect current economic realities.

Although U.S. equities have continued to outperform their international peers, the primary driver of that outperformance has shifted from earnings to currency over the last year. The 30% decline in emerging markets over the past 12 months has made valuations in those regions more attractive. We now expect similar returns to those of non-U.S. developed markets and view emerging markets as an important diversifier in equity portfolios.

Within the U.S. market, value stocks are fairly valued relative to growth, and small-capitalization stocks are attractive despite our expectations for weaker near-term growth. Our outlook for the global equity risk premium is still positive at 1 to 3 percentage points, but lower than last year because of a faster increase in expected bond returns

Continue Reading…

Canada’s Real Estate Affordability Battle

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By Dale Roberts, cutthecrapinvesting

Special to the Financial Independence Hub

In my latest for MoneySense, I look at the affordability battle in Canada. Home prices are falling at the fastest clip in the last 20 years. But borrowing costs are also increasing. Mostly, it’s a wash. Even from the bubble peak in February of 2022 to July 2022, things have not improved for homeowner wannabes. Real estate is the most interesting and ‘exciting’ sector in 2022. Have a read of the real estate affordability battle in Canada.

Higher rates take on falling home prices on MoneySense.

In this post I will offer up a few of the important charts, but check out that MoneySense post for the wider perspective.

Average home prices down 22% in July

Home prices are falling fast. After a strong COVID-inspired real estate run, prices are now in a free fall. After peaking at $816,720 in February 2022, the national average house price fell 18.5% to $665,850 in June. The average price fell again in July, settling at $629,971—nearly 22.9% below the peak.

The average national home price in August increased to $637,673.

CREA

The national average price is heavily influenced by sales in Greater Vancouver and the GTA, two of Canada’s most active and expensive housing markets. Excluding these two markets from the calculation cuts $114,800 from the national average price.

Real estate ridiculousness

And here’s some longer term history using average Toronto home prices as an example. It was a crazy run.

  •  Average Toronto home price in 2000: $243,255
  •  Average Toronto home price in 2010: $431,262
  •  Average Toronto home price in 2021: $1,095,336

Rates are going up, up, up

In that battle against runaway inflation, central bankers are raising rates. Borrowing costs mostly follow suit. Here’s the path in Canada for fixed and variable rates mortgages.

And of course, on Wednesday September 7, the Bank of Canada increased rates another 75 bps, or 0.75%. Variable is getting more expensive.

  • A 5-year fixed will now run you about 5.04%.
  • A 5-year variable will increase to about 4.90%.

The B0C offers that they’re not done yet. There are more rate hikes to come.

Given the outlook for inflation, the Governing Council still judges that the policy interest rate will need to rise further. Quantitative tightening is complementing increases in the policy rate. As the effects of tighter monetary policy work through the economy, we will be assessing how much higher interest rates need to go to return inflation to target. The Governing Council remains resolute in its commitment to price stability and will continue to take action as required to achieve the 2% inflation target.

Bank of Canada

Variable rates will automatically follow Bank of Canada rate hikes. Fixed rates will follow the bond market, and the bond market will make a guess about the near and future path of rate hikes. The rate hike on September 7 was mostly already priced into the bond markets.

The money chart on affordability

In the MoneySense post you’ll find the telling table comparing costs for variable and fixed rate mortgages, for 10% and 20% down payment scenarios. Here was the working copy table. Continue Reading…