Stock Returns Are Predictable But Not Rationally So

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John Rekenthaler has published an interesting article about Shiller’s CAPE ratio at the Morningstar site. It is titled Maybe There’s Something to the Shiller CAPE Ratio, after all.

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Rekenthaler's Skepticism Of CAPE Ratios

Rekenthaler describes himself as a CAPE skeptic. He acknowledges seeing some potential in the tool because, historically, “as CAPE ratios increased, the rate of total return declined.” However, “it would have been very difficult to put this information to use because the relationship was too weak. Most of the highest future returns, at a flashy 19 percent to 20 percent annualized, followed relatively steep CAPE ratios. What’s more, when the CAPE ratio reached peak levels, the ensuing performance was acceptable, at 8 percent to 12 percent. No disasters ensued.” Thus, “I have long dismissed attempts to employ the CAPE ratio” to predict returns.

However, a recent article in Advisor Perspectives -- The Remarkable Accuracy of CAPE As a Predictor of Returns, by Michael Finke -- has caused Rekenthaler to soften his skepticism a bit. Looking at Finke’s work, which looks at how CAPE has worked as a predictor of returns from 1995 forward, Rekenthaler declares: “Now that’s a correlation. Have you ever seen such a tight fit between a stock-market signal and future performance? If so, let me know because I cannot think of such an example.”

Still, Rekenthaler concludes that: “the CAPE ratio's predictive power has not benefited investors” because no one knew that the CAPE metric would suddenly take on greater predictive power in the mid-90s.

I believe that CAPE is an exceedingly powerful tool of investment analysis. But I do not believe that it will ever be able to provide the sorts of precise predictions that many demand of it before they will begin making use of it in their own portfolio construction.

Shiller's Findings Changed The Rules Of Investment Analysis

The point that does not seem to click for Buy-and-Holders is that Shiller’s research findings changed the rules of the game of investment analysis. Pre-Shiller, the idea was to make sense of stock investing. Shiller showed that that is not possible. Investors are not rational. The exuberance that they show in pushing stock prices up to high levels is not grounded in anything. It comes and it goes. And we are never going to be able to know in advance when the coming or the going will take place. Irrational phenomena cannot be explained by making reference only to the dictates of logic.

Consider Rekenthaker’s’s statement that: “Most of the highest future returns, at a flashy 10 percent to 20 percent annualized, followed relatively steep CAPE ratios.” He is indeed pointing to a surface contradiction. If CAPE levels always correct to the mean, a high CAPE level signals a sharp price drop. If we often see big returns following high CAPE levels, CAPE doesn’t work. Right?

That’s not right. It is correct that a high CAPE level tells us that we will be seeing sub-normal returns in coming years. But it does not tell us how those sub-normal returns will appear before us. It could be that there will be several years of better-than-normal returns followed by several years of scary-bad returns. The CAPE level does indeed correct to the mean. But it does this in all sorts of crazy ways. Buy-and-Holders want to see the CAPE level correct in a rational manner. That is just not a reasonable thing to expect given Shiller’s finding that much investor behavior is irrational.

I like to compare the investor behavior that produces sky-high returns to the behavior of alcoholics. Buy-and-Holders hate the comparison because they cling to the comforting belief that most investor behavior is rational. But Shiller showed that much investor behavior is not rational, especially at times when prices are high. I like the comparison because the full reality of alcoholism is that alcoholics are capable of a great deal of intelligent, productive behavior. The drinking is not intelligent and productive. But the reason why alcoholics are able to continue functioning as long as they often do is that they supplement their irrational behavior with a lot of behavior that is even more focused than the behavior of many non-alcoholics. The alcoholism is the exception as is the irrational exuberance of stock investors at times of high prices.

The Correlation Of CAPE Value And Price Drops

A high CAPE value does not signal an immediate price drop any more than a discovery that a friend has permitted his drinking to get out of control signals an immediate sobering up. There is a possibility that heavy drinking will cause an alcoholic to hit bottom and sober up. But there is every bit as strong a possibility that heavy drinking will cause the alcoholic to experience deep feelings of guilt, which will cause him to drink more.

So it is with the bull-market stock investor. High prices scare investors. So they can bring on price drops. But high prices also excite investors. So they can bring on even higher price jumps. All that we can really say about high CAPE values is that they signal either a sharp increase in the CAPE value or a sharp drop in the CAPE value.

So a high CAPE value tells us nothing?

No, that’s not so. A high CAPE value signals that either a sharp increase or a sharp drop is likely coming soon. And a sharp increase will tilt the odds farther in the direction of a sharp drop in the following time-period. What a high CAPE is really telling us is that risk has reached dangerous levels. If you elected your stock allocation with the aim of maintaining a certain risk profile, you should respond to a high CAPE value by lowering your stock allocation regardless of whether you expect prices to rise or fall in the short term because you need to lower your allocation to get your risk profile back where you had intended it to be.

It’s hard sometimes to make sense of Shiller’s research findings because he showed us something that we very much did not expect to find -- Many of our investment choices are irrational. We don’t like hearing it but that is just why we very much need to consider the possibility. It is the things that we don’t like hearing that become our blind spots and it is our blind spots that always end up causing us the most pain down the line a bit.

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