The level of stock markets differs widely across countries. And right now, the United States is leading the world. What everyone wants to know is why—and whether its stock market’s current level is justified.
We can get a simple intuitive measure of the differences between countries by looking at price-earnings ratios. I have long advocated the cyclically adjusted price-earnings (CAPE) ratio that John Campbell (now at Harvard University) and I developed 30 years ago.
The CAPE ratio is the real (inflation-adjusted) price of a share divided by a ten-year average of real earnings per share. Barclays Bank in London compiles the CAPE ratios for 26 countries (I consult for Barclays on its products related to the CAPE ratio). As of December 29, the CAPE ratio is highest for the United States.
Let’s consider what these ratios mean. Ownership of stock represents a long-term claim on a company’s earnings, which the company can pay to the owners of shares as dividends or reinvest to provide the shareholders more dividends in the future. A share in a company is not just a claim on next year’s earnings, or on earnings the year after that. Successful companies last for decades, even centuries.
So, to arrive at a valuation for a country’s stock market, we need to forecast the growth rate of earnings and dividends for an interval considerably longer than a year. We really want to know what the earnings will do over the next ten or 20 years. But how can one be confident of long-term forecasts of earnings growth across countries?
In pricing stock markets, people don’t seem to be relying on any good forecast of the next ten years’ earnings. They just seem to look at the past ten years, which are already done and gone, but also known and tangible.
But when Campbell and I studied earnings growth in the United States with long historical data, we found that it has not been very amenable to extrapolation. Since 1881, the correlation of the past decade’s real earnings growth with the price-earnings ratio is a positive 0.32. But there is zero correlation between the CAPE ratio and the next 10 years’ real earnings growth. And real earnings growth per share for the S&P Composite Stock Price Index over the previous 10 years was negatively correlated (-17 percent since 1881) with real earnings growth over the subsequent 10 years. That’s the opposite of momentum. It means that good news about earnings growth in the past decade is (slightly) bad news about earnings growth in the future.
Essentially the same sort of thing happens with U.S. inflation and the bond market. One might think that long-term interest rates tend to be high when there is evidence that there will be higher inflation over the life of the bond, to compensate investors for the expected decline in the dollar’s purchasing power. Using data since 1913, when the consumer price index computed by the U.S. Bureau of Labor Statistics starts, we find that the there is almost no correlation between long-term interest rates and ten-year inflation rates over succeeding decades. While positive, the correlation between one decade’s total inflation and the next decade’s total inflation is only 2 percent.
But bond markets act as if they think inflation can be extrapolated. Long-term interest rates tend to be high when the last decade’s inflation was high. U.S. long-term bond yields, such as the 10-year Treasury yield, are highly positively correlated (70 percent since 1913) with the previous 10 years’ inflation. But the correlation between the Treasury yield and the inflation rate over the next 10 years is only 28 percent.
How can we square investors’ behavior with the famous assertion that it is hard to beat the market? Why haven’t growing reliance on data analytics and aggressive trading meant that, as markets become more efficient over time, all remaining opportunities to secure abnormal profits are competed away?