The last 15 years

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lee1026
Posts: 395
Joined: Sat Jun 21, 2014 7:47 pm

Re: The last 15 years

Post by lee1026 »

As you say, the length of time it tends to take markets to revert to more normal valuations could be radically different in the future - considering the impact hedge funds can have on market behaviour, as well as potentially index investing .. But that doesn't matter .. Valuations are a very simple principle (as noted above) - turning them into estimates is a much fuzzier science

In real terms, CAPE has tended to be most predictive over about 15-20 years .. This chart demonstrates historical correlations over different time periods
My google-fu is failing me quite a bit, but a few years ago, people tend to say that CAPE is predictive over 10 years. Now, it is 20 years. CAPE is a roughly 20 year old theory, so these timings are very suspicious.

I don't dispute that CAPE did awfully well before the 1990s to predict long term returns, but the 20 years of real data haven't been kind. Notice how the valuations never really reached the "normal" levels from the pre-90s era after CAPE have became a popular metric?
Now, would there be any compelling reason (looking at the data) to presume average CAPE ratios are likely to be higher in the future?
There is a quite a few reasons to suspect that the average CAPE ratios are going to be higher in the future. List me list out the big few:

1. The performance of stock market in the past have been called the Equity premium puzzle. That given the risks and rewards of the stock market have provided in the 20th century, you have to be an absolute fool to invest in anything else, which is puzzling to the efficient market types. HIgher valuations should in theory lead to lower returns, which should at least get rid of the puzzle.

2. The earnings that we use in these calculations is a bit of an imaginary number. Depreciations rules have a massive effect on reported earnings, but they don't really affect the underlying businesses. Companies have been good at convincing the IRS how they didn't really make much money even though they actually did, which saves them money on taxes. (See: Amazon) But it also throws off simple PE calculations. This is closely related my objections to calling investing in companies based on price-to-book and calling it "value" investing.

3. Interest rates are lower, so the opportunity cost of investing in the stock market is lower.
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