The US market has experienced long periods without a new high in real earnings per share. In 1916, on the eve of US involvement in World War I, real per share earnings for a capitalization-weighted market portfolio peaked and did not achieve a new high, adjusted for inflation, until the end of 1950, 34 years later. Obviously, no one should harbor the illusion that earnings will hit new highs with every market or economic cycle. What was the warning sign in 1916? Profits were very near record levels as a share of GDP.
In our view, the recent trend of rising US corporate profits has likely run its course. Can real wages, unchanged for decades, continue to stagnate without a backlash from workers? Populist pressures that can inhibit global trade and immigration, and can promote redistribution, seem unlikely to go away. All of these forces represent headwinds capable of stalling (or reversing) recent growth in profits as a share of GDP.
What’s Right With CAPE?
By dwelling on the potential flaws of a metric such as CAPE, it’s easy to become disillusioned and want to disregard it completely. Before we do that, let’s review what CAPE brings to the table. CAPE shows remarkable efficacy in forecasting long-term equity returns, not just in the United States but across the world, providing investors a consistent tool for comparing potential equity market investments. The fit is imperfect, but impressive.
Figure 3 showed that CAPE within each country is a powerful predictor of that market’s return, albeit with each country having a different equilibrium level of CAPE. Should we not question paying $32 for every $1 of earnings in the United States when Canada is trading at 20x earnings, Germany at 19x, and the United Kingdom at 14x, especially when these three markets are all trading near their respective historical CAPE norm and the United States is not?
We acknowledge that a country’s multiple reflects the unique risks of that country. For example, Canada relies heavily on its resource industries, the United Kingdom is grappling with Brexit, and Germany faces uncertainties about the future of the EU and the euro. Accurately assessing how these risks will affect each nation’s future growth prospects and respective discount rates is difficult. Nevertheless, we have confidence in stating that if the differences in CAPE levels arise solely from differences in discount rates associated with different levels of risk, then we should expect higher rates of return for the more cheaply priced countries, suggesting, at the very least, caution is warranted in our consideration of allocating to high-multiple countries. Our observation is not intended as a recommendation of any specific country, but simply to make the point that CAPE allows this type of comparison.
The rationales offered by many to justify the high CAPE ratios in the US market are no less applicable in international markets, and therefore allow for the same type of analysis. An aging population with an urgent need to save? No less true for Europe or Japan. Low interest rates that allow higher multiples due to a reduced discount rate? Europe and Japan have even lower rates. Record lows in macroeconomic volatility permitting higher multiples and lower yields? No less true for most of the rest of the world. Why, then, should US CAPE be significantly higher than the CAPE of other developed markets?
We use CAPE in our Asset Allocation Interactive (AAI) website tool. Figure 10, derived from data on AAI, compares our projected returns for the 12 markets included in Figure 3. The green bars in Figure 10 assume CAPE ratios and currencies move just halfway back to historical valuation norms over the next decade. In the US market, the most recent CAPE points to a 10-year real return expectation of 0.4 percent, reflecting a revaluation headwind of 2.8 percent a year for current valuation levels. The other developed markets have expected real returns ranging from 3.0 percent to 7.5 percent, in US dollars. These higher forecasted returns are due partly to higher current dividend yields, but also to less risk of a tumbling CAPE ratio in the years ahead, paired with expectations of currency appreciation in countries with recently depressed currencies.