Wade Pfau on High CAPE ratios

[Packman]

Quote:

Originally Posted by NW-Bound It makes sense to be cautious when P/E is high, whether the current value or a sliding average over past years like PE10. But for portfolio allocation, should we not also consider the prospect of alternative investments, such as bonds, precious metals, cash, etc...? Right now, the other asset classes do not look appealing either.

+2. It would be nice to see someone recommend other investment options and how they forecast other options, especially in today's economy.

[clifp]

Quote:

Originally Posted by samclem Other work done by Pfau and Kitces suggested that, in reaction to PE10, investors should not only vary their % in equities, but change the "safehaven" from corporate bonds to ST govt bills when PE10s get high. I think the explanation for the historical outperformance of this strategy is that when the markets take a big drop (from a high PE10) that the subsequent "flight to quality" favors govt bills, but that the higher return from corp bonds during periods of more moderate equity valuations make them the better choice. What Pfau is writing about in the links at the OP is ground he has covered before recently. We discussed it a bit here.

But S/T government bonds offer near 0 nominal returns and negative real returns. Even if the the yields of stocks is only 1.5% over the next 10 years isn't that still better than 90 day T-bill at .03%

[samclem]

Quote:

Originally Posted by clifp But S/T government bonds offer near 0 nominal returns and negative real returns. Even if the the yields of stocks is only 1.5% over the next 10 years isn't that still better than 90 day T-bill at .03%

If stocks go down 30% and people rush to buy bills/ST govt bonds, the ones we already own will probably go up in value considerably more than .03%. So, today's yields don't necessarily tell us what we'll earn on those assets.

[Fermion]

Quote:

Originally Posted by samclem If stocks go down 30% and people rush to buy bills/ST govt bonds, the ones we already own will probably go up in value considerably more than .03%. So, today's yields don't necessarily tell us what we'll earn on those assets.

Exactly how much would you expect a bond paying 0.03% to go up to be considered considerable? I guess a $100,000 bond might go up to $100,010 and you could use that extra $10 to buy into the lower stock market.

Or just hold some cash.

[samclem]

Quote:

Originally Posted by Fermion Exactly how much would you expect a bond paying 0.03% to go up to be considered considerable? I guess a $100,000 bond might go up to $100,010 and you could use that extra $10 to buy into the lower stock market. Or just hold some cash.

The broad US equity indexes decreased substantially in value between Jun of 2007 and Jun of 2009. During this period, Vanguard Short Term Govt (VSGDX) shares appreciated about 9%.

[photoguy]

Quote:

Originally Posted by NW-Bound Do we call "noise" a myriad of other factors, things that are too complicated to consider in a simple number like PE? What about lack of other investment opportunities, low interest rates, low bond yields, few foreign markets with geopolitical stability, currency exchange rate, etc...?

These all seem to be reasonable factors to include in a model but I think due to feedback inherent in the market (especially positive feedback which is unstable) including these would at best result in a minor improvement (e.g. a few extra percent variation explained).

I'm not aware of any research where PE10 has been substantially bettered by a more complex model. This could be because I don't follow the literature closely however I think more likely is that people/researchers have tried but just obtained negative results.

Quote:

Originally Posted by haha I wonder if PE10 modified by some sort of momentum factor to prevent a very early exit from a blow-off might not help? It might be that in our modern era of politically controlled markets you do better by being less than completely rational.

In my original statement, I meant that the PE based prediction of returns in 10 years won't get much better. However i do believe that trading strategies based on PE10, could potentially yield benefits and momentum might be useful.

But personally I haven't seen a lot of rigorous analysis on PE based trading and I don't have the chutzpah to do it myself. Also to some extent a fixed AA approach will also shuffle more money into slices with low valuations.

Quote:

Originally Posted by samclem That's true. But if Pfau's data and analysis is right, when equities are in the present range, they typically return about 1.5% over the next 10 years.

I think "typically" is not quite the right word here. It suggests that a return of 1.5% will be common in the current circumstance. I think this understates the variance -- 1.5% is the center of the distribution of returns but the distribution is going to be pretty wide.

[Fermion]

Quote:

Originally Posted by samclem The broad US equity indexes decreased substantially in value between Jun of 2007 and Jun of 2009. During this period, Vanguard Short Term Govt (VSGDX) shares appreciated about 9%.

This isn't the 2007 bond market.

[samclem]

Quote:

Originally Posted by Fermion This isn't the 2007 bond market.

But it is close to the 2007 equities market. S&P PE10 is now 27.19, on Jan 1, 2007 it was 27.21. (Link to PE10 chart). So, (IMO) the more important question is whether to decrease equity holdings at times like this and seek a refuge somewhere else for an increased amount of the portfolio (ST corp bonds, ST govt bonds, or even cash, as you suggested). Which "refuge" is chosen may be less important. Given that this PE10 timing thing is far from precise and can be "wrong" for a long time, an investor should probably choose something with yields and interest rate sensitivity he can live with.

[DEC-1982]

I don't recall whether profits were terrible in 2007/2008/2009. If they were, will PE10 fall dramatically once those bad profit years stop being counted in a few years?

[Totoro]

Quote:

Originally Posted by DEC-1982 I don't recall whether profits were terrible in 2007/2008/2009. If they were, will PE10 fall dramatically once those bad profit years stop being counted in a few years?

There's that .. earnings index

Earnings 2007: 954
Earnings 2008: 569
Earnings 2009: 198
Earnings 2010: 805
Earnings 2011: 1008

If you choose to discount 2009 you can roughly subtract 10% from the PE-10. Still ends up at 25x (4%). Lofty but not 1999 crazy.

[Lsbcal]

Quote:

Originally Posted by DEC-1982 I don't recall whether profits were terrible in 2007/2008/2009. If they were, will PE10 fall dramatically once those bad profit years stop being counted in a few years?

This is a good question. I've been keeping a chart that uses the Schiller excel data to show some of the underlying variables.

In particular the standard deviation of the 10 year earnings has been rising since the 1990's. The PE1 over recent years would indicate where PE10 will wind up if earnings stay around where they are now. In short, if the real earnings hold up over the next 5 years, we should be closer to more normal PE10's.

In January 2015 the numbers were PE15=30.6, PE10=26.5, PE5=23.4, PE1=20.0.


.

[Totoro]

Just counterpoint (yeah I know) -- aren't the earnings of 2015 in % terms (profit margin of companies) at record highs now?

[Lsbcal]

Quote:

Originally Posted by Totoro Just counterpoint (yeah I know) -- aren't the earnings of 2015 in % terms (profit margin of companies) at record highs now?

Looking at Schiller's data, from Jan 2010 to now the real growth of the SP500 (price appreciation) has been 11.6% per year. Meanwhile the real growth in earnings was 10.5% per year. Then we should add in the dividends which were maybe 2% per year. Pretty nice.

I did a "what if" using the Schiller data to determine a final PE10 out in the future. Suppose the SP500 went up at 7% per year, and the earnings went up at 6% per year from now. It turns out that the PE10 would be about 26.8 in January 2020. So we could have a total return of maybe 7% + 2% dividends = 9% per year and the PE10 could stay about where it is now.

If the SP500 just went up 3% per year and the earnings just 2% per year, the Jan 2020 PE10=23.6 .

[Totoro]

I'm not so much concerned about growth in profit as I am in very high profit margins (profit as % of revenue) -- that seems to be at record highs (don't have the numbers on hand) and if so may be unsustainable?

As in, total S&P 500 earnings may drop 20% or more.

[Lsbcal]

So far the market doesn't see this happening. Always a possibility of low probability events coming true.

[HFWR]

i've never been totally convinced that the stock market is a leading indicator...

[dallas27]

Quote:

Originally Posted by Totoro I'm not so much concerned about growth in profit as I am in very high profit margins (profit as % of revenue) -- that seems to be at record highs (don't have the numbers on hand) and if so may be unsustainable? As in, total S&P 500 earnings may drop 20% or more.

Margins will only drop once companies start trying to grow quickly to maintain market share, meaning the economy is getting awesome again. They will get big and fat, then the cycle will turn, they layoff everyone to get small and lean again to boost those margins. That's the cycle.


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