Today’s CAPE value is 37. The CAPE value in January 2000 was 44. The mean CAPE value is 16. That means that stocks were priced at more than two times their real value in January 2000 and are again priced at more than two times their real value today. Both price levels are scary high. The difference is that risk was a bit greater in January 2000. Today’s prices are bad. But at least they are not the worst that we have ever seen in history.
Stocks Are More Risky Today
I don’t believe that. It’s true that today’s prices are not quite as bad as what we saw in January 2000. But I believe that stocks are more risky today. The CAPE value is an important signifier of risk. But it is not the only signifier that should be taken into consideration.
The reason why a high CAPE value signals danger ahead is that the market always returns stock prices to their fair-value level. The core purpose of any market is to get prices right. So, when the CAPE value is a bit above 16, there is a small downward pull on prices. When the CAPE value is as high as it is today, that downward pull is very strong. These are dangerous times to own stocks, according to Shiller’s research showing that valuations affect long-term returns.
If all else were equal, stocks would not be quite as dangerous today as they were in January 2000. The downward pull is not quite so strong. But all else is not equal. There is another factor that needs to be taken into consideration by the investor seeking to develop an informed take re where prices are headed in the coming years.
The other factor is the force that determines CAPE values in the first place -- investor psychology. When investors pushed the CAPE value up to 44, they were sailing in uncharted territory. Until the late 1990s, we had never seen a CAPE value of more than 33, the CAPE value that brought on the Great Depression. So the “44” number was truly scary. Even today, it is hard to let in how out of control the bull market was in that day.
The fact that we are still here shows that we can survive a CAPE value of “44.” That super high CAPE value has kept the annualized return on the S&P 500 to 4.8 percent real (with dividends reinvested), a good bit lower than the average return of 6.5 percent real. And I believe that it was the primary cause of the 2008 economic crisis (as stock prices fell, consumers did not feel comfortable spending as much and the economy contracted sharply). But other than that, the damage has not been great. Most Buy-and-Holders are perfectly content with how their strategy has performed over the past two decades.
Valuation-Informed Indexers vs Buy-and-Holders
Valuation-Informed Indexers have a different reaction to that reality than do Buy-and-Holders. Buy-and-Holders see it as great news. Buy-and-Holders believe that stock prices reflect economic realities. So the fact that the stock market was performing reasonably well means that the economy was performing reasonably well. Good performance by the economy makes us all richer. So the story of the past two decades has been a generally positive one, in the assessment of the Buy-and-Holders.
The Valuation-Informed Indexers have a very different take. We believe that stock prices reflect economic realities only when stocks are priced at something close to their fair-value price. That hasn’t been the case during the past two decades. Stocks have been dramatically overpriced for almost that entire time-period (the lone exception was a time-period of a few months immediately following the 2008 crash). So investors have been misled about how much accumulated wealth they possess for that entire time-period.
Bull markets are transformed into bear markets when investors come to see that the bull market prices that they are counting on to finance their retirements are illusory. It’s the growing awareness of the gap between the bull-market fantasy and the underlying economic reality that causes feelings of panic to develop. Stock prices were most an illusion in January 2000. But prices had only reached dangerous levels in 1996. So the illusion had not been in place for too terribly long a time. That means that the shock that would have been felt by investors if prices returned to fair-price levels would not have been as great as the shock that will be felt if the market returns to fair-price levels in the not-too-distant future.
WHy Today's Prices Are Bad?
Today’s prices are bad in two respects. One, they are very high. Two, they have been very high for a very long time. That means that investors have been making ill-informed (because they did not know the true value of their stock portfolio) spending decisions for a very long time. Coming to terms with reality today will be much harder than it would have been in January 2000. The feelings of shock and disappointment and panic and regret will be greater. Those are the things that cause stock prices to crash when they crash.
The longer that a bull market lasts, the harder it is to overcome its negative consequences and to restore a feeling of normalcy to investors and to the economic system in which they live. There have been many occasions over the past two decades when there were signals that prices might be about to crash and when Buy-and-Holders celebrated the fact that a crash did not take place. I have long felt that that was an unfortunate reaction.
The best stock prices are fair-value stock prices because fair-value stock prices permit us all to plan our financial futures effectively. Keeping stock prices at high levels makes investors happy in the short run. But it makes it harder for them to face up to realities down the road a piece. The harder it is for investors to face up to realities, the more pain a bear market delivers.
We are in a terrible fix today, in my assessment. My view is that we are in a worse spot than we were in when the CAPE value hit 44, the highest level it has ever visited in U.S. history.
Rob’s bio is here.