Are Grantham and Hussman Correct About Valuations?
The definition of floccinaucinihilipilification is the estimation of something as valueless. It is rarely used (for obvious reasons) and encountered primarily as an example of one of the longest words in the English language. I have been waiting for just the right occasion to employ this word, and I finally found it: Little deserves my use of floccinaucinihilipilification so much as relying on the historical average of the Shiller CAPE 10 to determine whether stocks are undervalued or overvalued. It can’t be used to time the market, despite the advice of the gurus who rely on this metric.
For several years now, well-respected financial experts such as Jeremy Grantham of global investment management firm Grantham Mayo van Otterloo (GMO) and John Hussman of Hussman Funds have been cautioning investors that the market, specifically the S&P 500, is vastly overvalued. Their warnings are based on the Shiller cyclically adjusted price-to-earnings (CAPE) 10-year ratio compared to its long-term average.
Their underlying assumption is that the ratio has a strong tendency to revert to its historical mean of 16.6 (Shiller’s website shows the historical data going back to 1871). Thus, when the CAPE 10 is above its average, stocks are expensive. Conversely, when the CAPE 10 is below its average, stocks are inexpensive.
Let’s turn to my trusty videotape to review some examples of warnings and predictions from Grantham and Hussman based on this metric:
In February 2012, with the Shiller CAPE 10 at 21.8, Grantham warned that investors who bought stocks at that time could expect meager returns over the next seven years. GMO forecasted that, after figuring for 2.5% in annualized inflation, U.S. large-cap stocks -- namely the S&P 500 --were poised to return slightly less than 1% per year, or under 3.5% in nominal terms. However, in 2012, the S&P 500 returned 16.0%. In 2013, it returned 32.4%. In 2014, it returned 13.7%. And through May, it has returned 3.3% in 2015. From March 2012 through May 2015, the S&P 500 produced a total return of about 65%.
In a mid-January 2013 letter, Hussman stated: “Present overvalued, overbought, overbullish, rising-yield conditions fall within a tiny percentage of market history that is associated with dismal market outcomes, on average. It’s true that we’ve observed extreme conditions since about March 2012 with little resolution aside from short-term declines. But the S&P 500 remains only a few percent from its March 2012 high, and if history is any guide, the extension of these unfavorable conditions is not likely to reduce the depth of the market loss that can be expected to resolve them.” From February 2013 through May 2015, the S&P 500’s total return was about 48%.
In mid-November 2013, with the CAPE 10 now at an even higher 24.6, GMO offered the following dire warning: “Combining the current P/E of over 19 for the S&P 500 and a return on sales about 42% over the historical average, we would get an estimate thatthe S&P 500 is approximately 75% overvalued.” The firm’s model gave them an estimated real return to the S&P 500 of -1.3% per year for the next seven years, after inflation. From December 2013 through May 2015, the S&P 500 has returned a total of about 20%.
In a March 2014 interview with Barron’s, and with the CAPE 10 having risen to 25.0, Grantham warned that stocks were 65% overpriced. From April 2014 through May 2015, the S&P 500 produced a total return of about 15%.
We can only imagine how overvalued Grantham and Hussman think the market is now that the Shiller CAPE 10 is currently at about 27.
Before moving on, I should make some important notes. Given that we are only about halfway through the period covered by Grantham’s 2012 seven-year forecast, he may yet turn out to be right. In Hussman’s case, he has written that the Shiller CAPE is one of several valuation metrics upon which he relies. However, market observers who draw conclusions based on the relationship between the current Shiller CAPE 10 and the historical mean are likely reaching the wrong ones.
We’ll look at five reasons why this ratio might be considered an inappropriate benchmark.