A Different Perspective on Market Valuations

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Investment managers who avoid overpaying for assets increase their odds of purchasing fruitful investments and limiting their drawdowns when investments turn against them. Shunning overpriced assets generates steadily growing investment returns, which has proven to be one of the most effective ways to grow wealth over time due to the underappreciated power of compounding.

While this approach sounds straightforward, investment prudence is typically disregarded in frothy markets such as we have today. It is also disregarded when markets are in the grips of fear as was most recently experienced in the financial crisis of 2008-2009. A previous article, To Win, the First Thing you Have to Do Is Not Lose, documented how the volatility of investment returns can significantly hamper portfolio growth over the long term. In particular, it stressed that large percentage losses require even larger percentage gains to simply recover original losses.

This article takes a unique, common-sense approach to describe the current market’s expectations for earnings growth in order to gauge the reasonableness of valuations and ultimately prices. This analysis helps determine if the currently elevated Cyclically Adjusted Price to Earnings Ratio (CAPE 10) reflects overly optimistic prospects causing investors to “overpay” for assets, or if it is an assessment based on realistic earnings expectations reflective of a market that is fairly priced or possibly undervalued. This determination is important as the CAPE 10, like most valuation metrics, is currently at a historical extreme.

CAPE 10 and its value

Robert Shiller’s CAPE 10 stands out amongst price to earnings (P/E) calculations in that it incorporates earnings over 10-year periods, while most other P/E measures use forecasted future earnings or a relatively short period of recent earnings. The longer time frame used in CAPE 10, which smooths earnings over a full business cycle, provides a better measure of earnings sustainability and -- according to Ben Graham and David Dodd -- offers a more dependable earnings proxy. It is this approach to earnings valuation that makes CAPE 10 a successful predictor of future market returns over time. The graph below, from John Hussman of Hussman Funds, documents the strong correlation between CAPE 10 and future 10-year equity returns and emphasizes the durability of this approach.

CAPE 10 Correlation with Future Market Returns

Graph courtesy of Hussman Funds (www.husmanfunds.com)