Each of these explanations has merit. But do they necessarily imply higher expected returns?
To answer this question we can use the dividend discount model that motivated the creation of CAPE. (A brief overview of the theoretical framework and history of the CAPE ratio is provided in the appendix.) We suggest three reasons why CAPE, measured at any point in time, can deviate from its historical norm:
1. Changes in the future EPS growth rate;
2. Inaccuracies in earnings measurement; and
3. Changes in the discount rate (and therefore changes in the expected rate of return).
If CAPE is high due to high future EPS growth expectations or is high due to mechanical imprecision in earnings measurement because past earnings are artificially depressed, and hence less indicative of future cash flows, then a high CAPE ratio is fully compatible with high expected future returns.
If CAPE is high due to a low discount rate, then a high CAPE would be associated with lower returns. High CAPE valuations do not need to tumble, to mean revert toward historical norms, in order to deliver lower returns. When discount rates are low, then expected future returns are low, even if valuations remain permanently elevated. The investor has simply paid a high price for future cash flows, and the future return will likely be lower than the historical norm.
Let’s examine the most common arguments used to dismiss the dangers of a lofty CAPE ratio.
Changes In The Future EPS Growth Rate
Grantham (2017) points out that US corporate profitability is very strong today. Both profit margins on sales and the ratio of corporate profits to GDP have been rising. He notes that strong profits are being driven by US companies’ greater monopolistic power, both domestically and abroad. Globalization has disproportionately benefitted US companies, allowing them to better leverage their brands. Further, increased political power of US enterprises in foreign markets has allowed them to reduce regulation in many industries and to squeeze unions into irrelevance. Finally, Grantham observes that much lower (and falling) interest rates, together with higher leverage since 1997, have also boosted US profitability. These are very sound reasons to explain high past EPS growth.
We agree that US corporate profits have been very strong lately and are beginning to regain the heights reached in 2014. The CAPE denominator has experienced an upward revaluation from higher profits that seems to reflect a “new normal” of higher profit margins. But should higher profits also boost the multiplier?
We question how past earnings strength is relevant to the CAPE ratio. The CAPE ratio should benefit only if the recent acceleration in earnings growth heralds continued outsized earnings growth for US companies, sustainable on a long-term basis. Assuming this will be the case could be dangerous because history suggests that fast earnings growth presages slower, not faster, earnings growth. Furthermore, an expectation that earnings will outpace real growth of GDP in the long term, especially when the latter has been disappointingly low during the most recent recovery, is difficult to understand.
In a nutshell, we think Grantham’s thesis is right on target in discerning the reasons for the past surge in corporate profits as a share of GDP. Real earnings of the S&P 500 peaked in 2014 and have yet to exceed that level, so Grantham’s earnings surge may already have run its course. We are skeptical that earnings can grow much in the years ahead, relative to GDP, without causing a populist backlash.