How Shiller's CAPE Ratio Is Important In Managing My Grandchildren's Section 529 Accounts.

When my two grandchildren were born, I established a Section 529 College Plan for each.  As you probably know, these are attractive because the capital appreciation in the account is tax-free, as are the distributions out of the account if they go toward financing the beneficiary's college education.

To illustrate how I use Shiller's CAPE ratio to help me manage these accounts, let's consider the account for my grandson.  It was just dumb luck that he was born in November, 2008--right after most stocks bottomed in October that year.  I began investing right away, and ultimately put in a total of $154,000.

The New York State 529 College Plan is managed by Vanguard, which allows the money to be invested in a number of their no-load mutual funds.  Unfortunately, Vanguard's Standard and Poor's 500 Index Fund wasn't one of the choices. I asked Vanguard to determine a mix of available funds that would correlate highly with the performance of that Index.  I invested in those funds.  As of last Friday, the account now totals $396,000.

I called my alma mater to find out what tuition, room, and board costs a freshman this year, which is
$70,000. And one could expect that number to compound at an annual rate of between 3% and 7%, he said. (At my fiftieth reunion, the compound annual growth during that half a century was 6.3%.)
So for planning purposes, I assume the worst--that college costs compound at 7% a year.

Now you might think that I would relax since my grandson's account already  has almost $100,000 a year in it, and there are almost ten years left before he enters college.  Wrong!

As you know, I have adjusted Shiller's mean CAPE ratio to take into account only his last fifty years of data.  My adjusted mean P/E ratio is 19.8, well above his 16.8.  As of Friday,  Shiller's CAPE ratio was 34.8, which means the Index is 75% overvalued using my adjusted mean P/E.  So, if mean reversion were to  occur immediately, the Index could fall 42%.  In that case, rather than $100,000 a year available, my grandson would only now have $58,000 a year--well below the actual cost of $70,000.  So rather than being well ahead, the account is really "behind the eight ball!"

Furthermore, the compound annual total return for the Index (inclusive of dividends reinvested) during  the next 10 years until he enters college is likely to be, at best, little more than 3%.  Meanwhile, annual tuition, room, and board could be $140,000  ten years from now.

So what's a grandfather to do?  I could take my chances and keep the account fully invested in equities.  Or I could reduce the equity exposure and bet that I can buy back at significantly lower prices.  Last Friday, I reduced the equity exposure to 50%.

This outlook is daunting for other long-duration accounts as well.  Most notable are the government pension funds who can't meet their future obligations without assuming an annual return of 7% over the next ten years.  They will be lucky to achieve 3%.  The difference must be made up by a combination of increasing taxes, borrowing more, or cutting entitlements.  Not a pretty picture!

I REMAIN A CAPE CRUSADER!

As you know, I rely on  Professor Shiller's CAPE ratio to determine when I rebalance my family's financial assets.  Yesterday it reached 33.5--roughly the high of the bull market that ended in 1929, before the stock market crash in October of that year. The only other time the CAPE was above this level was during the bull market that ended in March, 2000, when the CAPE reached 44.  (In a post called "WAITING FOR GODOT" written December 2, 2016,  I explained why I think the CAPE won't reach that lofty level this time.)

CAPE detractors are numerous and tend to become vehement at major market tops.  Why?   Professor Shiller recognized that business cycles exist, resulting in  profit margin cycles.  Wall Street practitioners in general have a bullish bias.  They tend to apply mean P/E ratios to peak earnings to determine fair value,  rather than the more reasonable approach -- applying them to mean earnings.  Thus, to them the market appears still cheap at market tops.  Shiller's CAPE concept "curbs the enthusiasm" of the bulls.

Recently CAPE logic seems even more under siege.

As I mentioned in my last post of October 23, 2016, the denominator of the CAPE ratio is the ten-year average annual earnings of the Standard and Poor's 500 Index ("the Index")  adjusted for inflation.  Because of this moving average construct, during the next two years the depressed earnings of the Great Recession will be dropped, and earnings during 2018 and 2019 will be added.  Hypothetically, even if actual earnings during the next two years were flat, the CAPE ratio,with the Index still at 2751, will have declined to the high twenties just because the ten-year average earnings would have increased.   This argument is valid, but it relies on a vagary in how the CAPE is calculated.  Once the U.S.  economy experiences the next recession, this effect will be reversed!

Also recently, one of the money managers I most respect hinted that recent elevated profit margins may be the "new normal" -- or  at least that these profit margins will be extended many years going forward.  He might be right. But to me he has uttered the most dangerous phrase in a money manager's lexicon, "This time it's different!".

Yesterday, the CAPE ratio reached 100% overvaluation.  As a CAPE crusader, I rebalanced. The sale proceeds remain in cash equivalents.

So long as the yield on the ten-year U.S. Treasury note remains under 3% (it is now at 2.58%) and earnings increase, the Index will have an upward bias. Once 3% is breached, a bear market should quickly ensue. As the Index becomes more overvalued, I shall continue to rebalance--next stop 110%.