Professor Robert Shiller’s CAPE ratio reached 28 recently. During the prior 135 years (i.e., 1620 monthly observations) there have been only 68 monthly readings at or above that level: 4 in 1929 with a CAPE high of 32.5, and 64 during the 1997 through April 1, 2002 period with a CAPE high of 44 in March 2000—the same month that Professor Shiller published his famous book “Irrational Exuberance”.
Why can’t the CAPE ratio approach 44 again? Here’s why: 1) the bull market in bonds, which began more than three decades ago, is over; and 2) the negative effect of demographics on P/E ratios, overwhelmed for years by the powerful positive effect of the Fed’s zero interest rate policy ("ZIRP"), will resurface now that the Fed is raising rates.
The More Than Three Decade Bull Market In Bonds Is OVER.
In a post dated July 10, 2014 entitled "Shiller's CAPE Versus the 10 year U. S. Treasury Note Yield--an Important Negative Correlation", I demonstrated that the CAPE ratio is negatively correlated with the ten year note yield. As interest rates rise, the CAPE ratio declines, and vice versa. That is mathematically how a dividend discount valuation model should work. In a number of posts I have suggested that the note yield bottomed around 1.35% in 2012 after more than three decades in decline; and that a secular uptrend in rates had started. After moving to a 3.0% yield in late 2013, the yield bottomed again around 1.35% this year--thus a double bottom has been formed.
Since the Trump victory, a little over three weeks ago, the note yield has jumped more than 50 basis points to 2.44% -- a rare event. Confirmation that a secular uptrend in the note yield has begun would require a break to the upside through the previous 3% high. If Trump's intended fiscal spending increases and tax reductions materialize, and average hourly wages continue to accelerate, then the 3% yield level should be penetrated. If that occurs, the yield could reach the 4.5% to 5.00% range within a year or so afterward -- completing interest rate levels reverting to their mean. In my opinion, mean reversion in the CAPE ratio would soon follow.
On the other hand, this move up in yields may prove to be a head fake like the one in 2013 -- a mere blip in the "new normal" slow growth, low inflation economy. Even better, perhaps the Trump effect would be to increase real growth significantly without much increase in inflation -- the desirable "goldilocks scenario." Were that to occur, then this bull market in stocks could continue -- albeit at a slower than normal pace. Hard to assign probabilities to these outcomes due to the political risk.
In a post dated July 10, 2014 entitled "Shiller's CAPE Versus the 10 year U. S. Treasury Note Yield--an Important Negative Correlation", I demonstrated that the CAPE ratio is negatively correlated with the ten year note yield. As interest rates rise, the CAPE ratio declines, and vice versa. That is mathematically how a dividend discount valuation model should work. In a number of posts I have suggested that the note yield bottomed around 1.35% in 2012 after more than three decades in decline; and that a secular uptrend in rates had started. After moving to a 3.0% yield in late 2013, the yield bottomed again around 1.35% this year--thus a double bottom has been formed.
Since the Trump victory, a little over three weeks ago, the note yield has jumped more than 50 basis points to 2.44% -- a rare event. Confirmation that a secular uptrend in the note yield has begun would require a break to the upside through the previous 3% high. If Trump's intended fiscal spending increases and tax reductions materialize, and average hourly wages continue to accelerate, then the 3% yield level should be penetrated. If that occurs, the yield could reach the 4.5% to 5.00% range within a year or so afterward -- completing interest rate levels reverting to their mean. In my opinion, mean reversion in the CAPE ratio would soon follow.
On the other hand, this move up in yields may prove to be a head fake like the one in 2013 -- a mere blip in the "new normal" slow growth, low inflation economy. Even better, perhaps the Trump effect would be to increase real growth significantly without much increase in inflation -- the desirable "goldilocks scenario." Were that to occur, then this bull market in stocks could continue -- albeit at a slower than normal pace. Hard to assign probabilities to these outcomes due to the political risk.
Demographics
On August 22, 2011 the Federal Reserve Board of San Francisco published a letter entitled “Boomer Retirement: Headwinds for U. S. Equity Markets?” written by Liu and Spiegel.
They showed how the movement of the Baby Boomers through their life cycles would impact the P/E ratio of the Standard and Poor's 500 Index ("the Index"). They measured the relationship over time between two population groups: the middle-aged 40-49 year olds (“M”) and the old-aged 60-69 year olds (“O”). Their hypothesis was that, as the boomers phased out of their work lives into retirement, equity values would be negatively affected—that as the M/O ratio declined, so would the P/E ratio of the Index.
Their study spanned from 1954 to 2010. The results were significant. As they put it, “In our model, we obtain a statistically and economically significant estimate of the relationship between the P/E and M/O ratios. We estimate that the M/O ratio explains about 61% of the movements in the P/E ratio during the sample period. In other words, the M/O ratio predicts long-run trends in the P/E ratio well.”
During the period from 1997 to early 2000, when the CAPE ratio rose to its all time high of 44, the M/O ratio was rising sharply as well. From 2000 to 2021, the M/O is expected to fall, then flatten out. So demographics will not provide a tailwind this time; but rather a significant headwind.
It is interesting to note that from 2010 (the end of the study) to the present, the relationship between the M/O and the P/E faltered. M/O continued to decline; P/E rose to its current level. The explanation—ZIRP. The positive effect on the P/E from the Fed’s seven year zero interest rate policy overwhelmed the negative demographic effect. Remember the M/O paper was published by the Fed. It occurs to me that not only was the Fed worried about an echo recession after the Great Recession, but also the Liu and Siegel paper may have influenced the Fed into prolonging ZIRP.
ZIRP has ended. Rising interest rates and a falling M/O ratio will be with us for the next five years. Together both should put serious downward pressure on the P/E ratio of the Index. That is why the euphoria of 1997 to March, 2000 will likely not be replicated over the next five years.
What To Do Now
The Index is at 2200. At 28, the CAPE ratio is 42% overvalued using my mean CAPE ratio (67% overvalued using Professor Shiller’s ). An immediate mean reversion would result in a 30% drop in the Index using my mean CAPE (40% with Professor Shiller’s). Even after the recent sharp rise in yield, the ten year note yield is still far from its mean, so mean reversion in the CAPE ratio is unlikely to occur immediately.
I have not rebalanced my financial assets in more than two years. As you may remember, I decided to rebalance not periodically such as once a year, but rather as the CAPE ratio indicates that the Index has become more overvalued. I had set as my next trigger point an overvaluation of 70%. However, I find the above analysis persuasive and have rebalanced my equity exposure back to my core 30% of financial assets. The sales proceeds remain in cash equivalents until mean reversions occur. Were this "Trump rally" to continue, I am prepared to rebalance again whenever: 1) the CAPE ratio becomes 80% overvalued based on Professor Shiller's mean CAPE of 16.7; or 2) whenever my sentiment indicator shows an extreme in bullishness.
I have not rebalanced my financial assets in more than two years. As you may remember, I decided to rebalance not periodically such as once a year, but rather as the CAPE ratio indicates that the Index has become more overvalued. I had set as my next trigger point an overvaluation of 70%. However, I find the above analysis persuasive and have rebalanced my equity exposure back to my core 30% of financial assets. The sales proceeds remain in cash equivalents until mean reversions occur. Were this "Trump rally" to continue, I am prepared to rebalance again whenever: 1) the CAPE ratio becomes 80% overvalued based on Professor Shiller's mean CAPE of 16.7; or 2) whenever my sentiment indicator shows an extreme in bullishness.
