There Can Be Good Reasons For The CAPE Value To Go Above 17

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The fair-value CAPE value is 17. That’s the mean value experienced over the history of the U.S. stock market. The median value is 16. The highest value we have seen is 44. The lowest is 5. Today’s CAPE value is 29.

When the CAPE value is near 17, investors should expect to obtain a long-term return of something in the neighborhood of 6.5 percent real, the average long-term return. When it is below that, one can realistically expect a higher return.

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When it is above that, one needs to be prepared for a lower return. When the CAPE value hit 44 in early 2000, a regression analysis of the historical return data showed that the most likely 10-year annualized return on stocks was a negative 1 percent real (in contrast, Treasury Inflation-Protected Securities [TIPS] were at the time paying a virtually risk-free return of 4 percent real).

Keeping The CAPE Value Close To 17

So we all should be doing what we can to keep the CAPE value as close to 17 as possible. Permitting it to go lower would suppress economic growth. Consumers would have less money to spend because their portfolio statements would be reporting artificially low portfolio amounts and the reduced spending would hurt businesses.

Permitting a CAPE value higher would also be a negative. Investors would have to return the pretend money somewhere down the line (the market’s core job is to eventually get prices right) and for the length of time that we were all enjoying our irrational exuberance gains it would become impossible for us to engage in effective financial planning; the first step to handling one’s money well is getting the numbers right.

The best CAPE value is 17. The longer the CAPE value remains somewhere near 17, the better off we all are as individual investors and the smoother is the functioning of the general economy (price crashes bring on economic contractions because spending dries up). The easy way to keep the CAPE value at 17 is through market timing.

As prices rise above that level, the long-term appeal of stocks is diminished. So informed investors should lower their stock allocation. The stock sales bring prices down to fair-value levels again.

All of that is clear enough, at least to me. But it needs to be noted that there really is nothing magical about the “17” number.

“17” is the mean CAPE value over the history of the market. If the United States were to enter a period of greater productivity than what we have seen over the past 150 years (we only have good records of stock prices going back to 1870), it could support a CAPE value of something higher than 17.

Conversely, it could be that we will be seeing in future years less economic productivity than what we have enjoyed in the past; some have argued that the 20th Century was “the American Century” – perhaps it is not reasonable to expect that level of productivity to be repeated. In the event that productivity drops, the fair-value CAPE value will drop with it.

We don’t know. No one can say with absolute certainty when stocks are overpriced or underpriced. That’s the bottom line.

Wait a minute! Something is wrong! I am sounding like a Buy-and-Holder!

The Requirement Of Market Timing

It’s true that we cannot know with precision the amount of overvaluation or undervaluation present in the market at a given time. But, when the Buy-and-Holders argue that market timing is not required, they are implicitly asserting that we cannot know anything. At the extremes, we can know quite a bit.

I mentioned above that the CAPE value hit 44 at the top of the bull market and that the historical data indicated that the most likely annualized return for stocks purchased at that time was a negative 1 percent real.

Stock market apologists of that day were arguing that the tech revolution was going to make us all rich beyond our wildest dreams. If that were so, maybe that CAPE value of 44 was not so insane. Perhaps the U.S. economy and thus the stock market were just becoming more productive.

No.

It was possible that the economy had become a bit more productive and that a slightly higher CAPE value was justified, No one could know that for sure. So if one wanted to make an argument that a CAPE value of 18 or 19 was okay, or, if one was of a more pessimistic nature, that a CAPE value of 15 or 16 was more appropriate, no one could have dismissed that claim out of hand. But 44? No.

That CAPE value was an absurdity. Every expert in this field should have been pointing out the absurdity of that CAPE value at that time.

We cannot say precisely what the CAPE value should be at a given time. There are circumstances in which a CAPE value above 17 could be justified by the economic realities. But we can say with a good bit of confidence what the proper CAPE value cannot be.

A CAPE value of 44 is so far off from the norm that it can safely be said that it is the product of irrational exuberance. Any CAPE value above 25 is dangerous. The entire history of the market tells that tale.

Rob’s bio is here.