PIMCO founder and CIO Bill Gross continues to examine how the New Neutral, the idea that the real fed funds rate is near zero instead of 1.75% as the Federal Reserve continues to assume, this time saying that it will change the way that investors use CAPE to decide if the market is overvalued.
“Even after accepting the historical validity and predictive capability of Robert Shiller’s CAPE (10-year cyclically adjusted P/E ratio), it may be necessary to make adjustments to it, if in fact real policy interest rates over the long term have settled into a lower New Neutral,” Bill Gross writes.
Bill Gross: CAPE may need to account for changing discount curves
One of the main criticisms of Shiller’s CAPE is that it compares earnings that aren’t necessarily equivalent because of changes to accounting standards. Gross is making a similar argument, saying that the changing discount curve (which affects the present value of future dividends) makes comparisons less meaningful. The current CAPE of about 25x is definitely high compared to the 17x historical median, but with if the real fed funds rate is zero, Bill Gross thinks that 17x is equivalent to about 20-22x CAPE today.
Looking back, Bill Gross says this way of thinking about CAPE also explains why multiples were so low in the 1980s.
“Do you wonder why stocks sold at P/Es of 6-7 times in 1981? Wonder no longer. It’s because nominal FF traded at 20%, and real FF at 7% or 8%. Equity risk premiums had to go up because real FF went up, which sent P/Es to what were rock bottom prices,” he said at the Morningstar Investor Conference, reprinted with today’s column.
New Neutral could usher in an ‘era of income’
PIMCO chief economist Paul McCulley covered a similar Gordon Model explanation of the New Neutral, but Gross takes this a step further and concludes that investors may have to move back to investing for income instead of capital gains for as long as real FF rates remain near zero, which he puts at 5 – 10 years. This isn’t news that anyone wants to hear, but he expects an aging population, liability-driven investors, and insurance companies to be behind a transition to more investment strategies centered on reliable income.
“The era of income may be, at the margin, replacing the era of capital gains, despite artificially low current yields,” he writes.