Quick question how to use cape10 to estimate returns

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jmk
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Quick question how to use cape10 to estimate returns

Post by jmk » Sun Jan 14, 2018 12:01 pm

In estimating returns does one need to adjust for the fact the CAPE10 earnings, though in real dollars, reflect "old" real earnings? More specifically, since real earnings tend to increase ~2% per year and the cape10 is on average 5 years old, do we need to multiply by 10%? I seem to remember Larry Swedroe doing something similar awhile back when using the Cape10.

In other words, is the expected return for today's cape10 of 32.66 equal to 1/32.66 * 110%?
Last edited by jmk on Thu Feb 15, 2018 9:35 am, edited 1 time in total.

jmk
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Re: Quick question how to use cape10 to estimate returns

Post by jmk » Thu Feb 15, 2018 9:34 am

bump.

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Tyler Aspect
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Re: Quick question how to use cape10 to estimate returns

Post by Tyler Aspect » Thu Feb 15, 2018 12:13 pm

I have been investing for more than 25 years, and I know enough to not even try predicting what my stock return is going to be next year. I will just say that future returns are inherently murky because it is in the future!

PE10 is mostly about historical records - not even good enough for a current snap-shot.

Vanguard would periodically publish estimates on future market returns. I thought their figures are more of a long term forecast, not intended for one year projection.
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jmk
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Re: Quick question how to use cape10 to estimate returns

Post by jmk » Thu Feb 15, 2018 4:59 pm

I'm talking about using Cape10 for a long-term (15-20y) forecast of expected returns.

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Ged
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Re: Quick question how to use cape10 to estimate returns

Post by Ged » Thu Feb 15, 2018 5:21 pm

jmk wrote:
Thu Feb 15, 2018 4:59 pm
I'm talking about using Cape10 for a long-term (15-20y) forecast of expected returns.
The error bands on such an estimate would be immense.

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willthrill81
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Re: Quick question how to use cape10 to estimate returns

Post by willthrill81 » Thu Feb 15, 2018 5:29 pm

Across the full spectrum of time horizons, the correlation just isn’t very strong. That’s because valuations aren’t reliably mean-reverting. There’s too much valuation variability in the historical data set, even when we use “Shillerized” averages over 10 year time spans. For the correlation to get tight, the growth and dividend errors have to superficially cancel with the valuation errors–but that doesn’t consistently happen, hence the breakdown.

Now, to be clear, I’m not saying that valuation doesn’t matter. Valuation definitely matters–its power as a return factor has been demonstrated in stock markets all over the world. Holding other factors constant, if you buy cheap, you’ll do better, on average, than if you buy expensive. This is true whether we’re talking about individual stocks, or the aggregate market.

What I’m taking issue with is the notion that we can use valuation to build “historically reliable” prediction models whose specific predictions closely align with actual past results, models that give us warrant to attach special “scientific” or “empirical” privilege to our bullish or bearish opinions. That, we cannot do. Given the significant variability in the historical data set, the best we can do is mine curve-fits whose errors conveniently offset and whose deviations conveniently disappear. These are not worth the effort.

In the end, valuation metrics are only capable of giving us a crude idea of what future returns will be. In the present context, they can tell us what we already know and accept: that future real returns will be less than the 6% historical average (a perfectly appropriate outcome that we should expect at equilibrium, given the secular decline in interest rates and the below-average implied returns on the assets that most directly compete with equities: cash and bonds). But they can’t tell us much more. They can’t arbitrate the debate between those of us who expect, say, 3% real returns for U.S. equities going forward, and who therefore judge the market to be fairly valued (relative to cash at a likely negative long-term real return), and those of us who expect negative real returns for equities, and who therefore find the market to be egregiously overvalued. The reason valuations can’t arbitrate that debate is that they don’t reliably mean-revert. If they did, we wouldn’t be having this discussion.
http://www.philosophicaleconomics.com/2 ... ixpercent/

To put it simply, valuations matter, but there are too many other factors at work for them to be a reliable predictor of the future. Others have gone down this path and found the exercise to be a futile one.

Take what the market gives you.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

staythecourse
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Re: Quick question how to use cape10 to estimate returns

Post by staythecourse » Thu Feb 15, 2018 5:38 pm

Please read Vanguard's paper on predictors of future equity returns which discuss PE1 and PE10 among others. Then decide if it matters to know the answer to your question.

Good luck.
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MathWizard
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Re: Quick question how to use cape10 to estimate returns

Post by MathWizard » Thu Feb 15, 2018 6:01 pm

I believe that the earnings in CAPE are already adjusted for inflation, which make sense.

Look at

Code: Select all

https://en.wikipedia.org/wiki/Cyclically_adjusted_price-to-earnings_ratio
for a definition and for the arguments for and against its predictive power.

I have read papers that suggest that the inverse of CAPE (called CAEP) is a decent predictor of
10 year returns, but not good outside of that range, which makes some sense, as it is long enough to
smooth out at least some of the business cycle, and it is using 10 year returns, so predictions would
seem to be better about 10 year returns.

Note that earnings can be paid out as dividends or retained, presumably causing an increase in price.
If the dividend yield changed over the 10 year period, I would think that would need causing problems with
CAPE's predictive nature, and some adjustment would need to be made for that.

JBTX
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Re: Quick question how to use cape10 to estimate returns

Post by JBTX » Thu Feb 15, 2018 6:17 pm

willthrill81 wrote:
Thu Feb 15, 2018 5:29 pm
Across the full spectrum of time horizons, the correlation just isn’t very strong. That’s because valuations aren’t reliably mean-reverting. There’s too much valuation variability in the historical data set, even when we use “Shillerized” averages over 10 year time spans. For the correlation to get tight, the growth and dividend errors have to superficially cancel with the valuation errors–but that doesn’t consistently happen, hence the breakdown.

Now, to be clear, I’m not saying that valuation doesn’t matter. Valuation definitely matters–its power as a return factor has been demonstrated in stock markets all over the world. Holding other factors constant, if you buy cheap, you’ll do better, on average, than if you buy expensive. This is true whether we’re talking about individual stocks, or the aggregate market.

What I’m taking issue with is the notion that we can use valuation to build “historically reliable” prediction models whose specific predictions closely align with actual past results, models that give us warrant to attach special “scientific” or “empirical” privilege to our bullish or bearish opinions. That, we cannot do. Given the significant variability in the historical data set, the best we can do is mine curve-fits whose errors conveniently offset and whose deviations conveniently disappear. These are not worth the effort.

In the end, valuation metrics are only capable of giving us a crude idea of what future returns will be. In the present context, they can tell us what we already know and accept: that future real returns will be less than the 6% historical average (a perfectly appropriate outcome that we should expect at equilibrium, given the secular decline in interest rates and the below-average implied returns on the assets that most directly compete with equities: cash and bonds). But they can’t tell us much more. They can’t arbitrate the debate between those of us who expect, say, 3% real returns for U.S. equities going forward, and who therefore judge the market to be fairly valued (relative to cash at a likely negative long-term real return), and those of us who expect negative real returns for equities, and who therefore find the market to be egregiously overvalued. The reason valuations can’t arbitrate that debate is that they don’t reliably mean-revert. If they did, we wouldn’t be having this discussion.
http://www.philosophicaleconomics.com/2 ... ixpercent/

To put it simply, valuations matter, but there are too many other factors at work for them to be a reliable predictor of the future. Others have gone down this path and found the exercise to be a futile one.

Take what the market gives you.
I agree that it isn’t very reliable as a forecasting tool. But I think it gives an signal of whether probable expected real returns will likely be higher or lower.

I tend to think 3% real is probably a mid point probable future return. Of course the actual may be higher or lower.

jmk
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Re: Quick question how to use cape10 to estimate returns

Post by jmk » Fri Feb 16, 2018 10:16 am

willthrill81 wrote:
Thu Feb 15, 2018 5:29 pm
quote
That quotation from philosophicaleconomics is spot on. To put it another way, the error band around the prediction is so great that 10% here or there is really a false confidence.

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