Should you reduce allocations to U.S. equities given the conventional wisdom that prices are “rich” and “due for a correction”? Jeremy Siegel says no; investors should expect 5% real returns from stocks over the long term. But Robert Shiller thinks that number should be much lower.

The two squared off in a keynote presentation yesterday at the CFA Institute Annual Conference in Philadelphia. Siegel is a professor at Wharton and author of Stocks for the Long Run. Shiller teaches at Yale, is the author of Irrational

Jeremy Siegel

Exuberance and the winner of the 2013 Nobel Prize in Economic Sciences.

Shiller and Siegel have been friends for nearly 50 years, since they were both students at M.I.T. But their analysis of equity prices diverged sharply.

The question is whether the cyclically adjusted price-to-earnings (CAPE) ratio, as conceived by Shiller, provides a valid forecast of future prices. More specifically, the central issue upon which the two differ is the appropriate measure of earnings to use in the denominator of that ratio – Shiller uses S&P earnings but Siegel claims that a broader measure, the national income and products account (NIPA), is more appropriate.

We’ve written about this debate previously (see here, for example). But Siegel and Shiller each made new claims. I’ll review Siegel’s and Shiller’s presentations, and provide some of my own thoughts on their analyses.

Shiller: The CAPE ratio works just fine

Shiller introduced the CAPE ratio in 1988, along with John Campbell, then his student. His rationale was that there is too much volatility in earnings over the course of a business cycle. Shiller developed the CAPE ratio with the conviction that,

Robert Shiller

by averaging over a trailing 10-year period, one could look at “normalized” earnings over the course of one full business cycle.

Essentially, the CAPE ratio smooths out earnings to provide a forecast of stock prices.

Although Shiller is deservedly credited with popularizing the CAPE ratio, the idea that earnings should be averaged and normalized over the course of a business cycle was suggested by Graham and Dodd in their book, Securities Analysis, published in 1934.

Shiller provided data showing that the CAPE ratio, as well as price-to-earnings and price-to-dividend ratios, are above average. But, he said, the NIPA-based CAPE suggests that prices are near historical averages. He cited research showing that other metrics – the price-to-dividend ratio, the price-to-book ratio and volatility (based on the VIX) – also indicate above-average valuations.

The CAPE, however, is statistically the best predictor of future returns over horizons of five years or longer. Shiller said that if you combine the CAPE ratio and interest rates, it has an r-squared of 0.41 when regressed against future returns, thereby explaining nearly half of the variation. Shiller has tested how well the CAPE forecasts returns in non-U.S. markets and found that, in all but two countries, the CAPE is the most reliable predictor.

Based on the CAPE ratio, Shiller predicted 1% excess returns (over inflation) for stocks over the next 10 years.

As for Siegel’s suggestion that NIPA earnings should be used instead of S&P earnings, Shiller said that idea was “interesting,” but “I have my doubts.”