Last year I wrote two intentionally alarming posts about the stock market. First, I pointed out that the stock markets have been seething with optimism since recovering from the pandemic dip in March 2020. And exuberant markets have often preceded past stock crashes. Second, I pointed out that almost every stock valuation measure in existence indicates that stocks are crazy expensive. Although these valuation measures can’t predict the next crash, expensive stocks have often led to poor returns for the next five to ten years.
I’ve written these pessimistic posts as a warning to anyone following a mindful investing approach, which involves holding a portfolio of mostly low-cost stock index funds. Specifically, stock-heavy investing is easy when the markets skyrocket as they have over the last decade, but it’s very hard when stocks crash or go sideways for years on end.
I’ve written tomes about why mindfulness is the perfect mindset for the emotional roller coaster of stock investing. But mindfulness is a tricky business. Some days are more mindful than others. Some meditation sessions are blissful, while others are frustrating. It would be nice if we could all stick to our long-term investing plans just through the sheer will to be mindful. But when mindfulness falters, other tools like rational thinking and empiricism, which also happen to be the foundations of mindfulness, can help too.
As of the date of this post, the S&P 500 is down about -10% since the start of 2022. And in typical fashion, the finance media is buzzing with unhelpful warnings of “superbubbles” and an imminent crash. So, in today’s post, I’m writing a more optimistic take on stocks using the tools of rational assessment and hard evidence. And perhaps, focusing on the more optimistic evidence about stocks can reduce some worries that you and I can’t quite quell just through mindfulness alone.
Stock Valuations Don’t Have To Revert
Let’s start with one of the most popular stock valuation measures, the Cyclically Adjusted Price Earnings (CAPE) Ratio. The CAPE divides the inflation-adjusted current price of the S&P 500 by the average of the last 10 years of inflation-adjusted earnings for those companies. The higher the CAPE ratio, the more pricey stocks are relative to the earnings they generate. Last year I emphasized the expensiveness of stocks by showing a CAPE graph similar to this one using data from Robert Shiller, the inventor of the CAPE.
The CAPE is currently at its second-highest reading ever, which seems scary. But I’ve added a couple of dashed horizontal lines to this graph showing the average of CAPE values over the last 30 years (26.95) versus the average for the 121 years before that (14.63). So, if stocks are expensive, they’ve been that way for the last 30 years with no sign of falling back to their long-term historical average. For example, the graph shows that even the huge crash of 2008 just barely managed to sink the CAPE briefly below the prior long-term average of about 15.
Will the CAPE Ratio ever revert to its prior lower averages? If the CAPE can levitate for 30 years, why can’t it stay aloft for 30 years more? Beyond such wishful thinking, there’s plenty of valid economic and market evidence suggesting that reversion to the lower long-term CAPE average is not guaranteed. I and others don’t necessarily agree with all of those arguments, but they can’t be simply dismissed as wild conjecture either.
Valuations Have Recently Declined
Another older method of stock valuation is the simple PE Ratio, which is the current price divided by the most recent earnings¹. This graph shows the simple PE for the S&P 500 using the same Shiller data. The graph also shows the inflation-adjusted averages of the simple PE for the last 30 years as well as the 121 years before that.
Like the CAPE Ratio, the simple PE Ratio has been consistently elevated for the last 30 years.
However, the graph below zooms in on the last few years showing that the Simple PE has recently declined by about 35% from its peak in late 2020.
In fact, the current PE is right around its average level for the last 30 years.
Last year, the S&P 500 generated a total annual nominal return of more than 28% including reinvested dividends. Despite that strong performance, stock valuations have substantially declined. That’s because earnings sky-rocketed in the same period as shown in this graph that separates recent S&P 500 prices from earnings.
I added the dotted line to show that the recent massive earnings jump was enough to regain the already strong trajectory of earnings that occurred between 2016 and 2019. Despite the pandemic, the earnings of S&P 500 companies have recovered back to a level optimistically consistent with a world where the pandemic never occurred.
Many observers point to government stimulus checks and Federal Reserve easing as the main reasons for these incredible earnings. However, if the underlying economy was completely anemic, it seems unlikely that earnings would have bounced back quite so energetically. And even a moderately healthy economy generally bodes well for future stock returns.
The CAPE Ratio has not yet registered recent declines similar to the simple PE only because the CAPE averages earnings over the last ten years. While the backward-looking CAPE Ratio has shown a good correlation with the next decade of stock returns, one has to wonder how relevant earnings from ten, or even five, years ago are to the question of what happens next.
Annualized Returns Are Still Within Historical Bounds
Given the strong performance of U.S. stocks over the last decade, you’d think that long-term annualized returns have reached unprecedented levels. But as this graph shows, the 10-year annualized returns of the S&P 500 still haven’t reached new highs, either on a nominal or inflation-adjusted basis.
And in case you think this pattern might be simply because of the timeframe I chose to calculate the rolling returns, here’s a similar graph using 5-year rolling annualized returns, which shows pretty much the same picture.
Going back to the 10-year rolling annualized returns, this next graph adds in the averages of those rolling returns for the last 20 years, last 30 years, and for the 64 years before that.
Because of the deep crash of 2008-2009, the subsequent 12 years of stellar returns have still not been enough to raise the 20-year average in line with longer-term averages. And I’ve noted before that if the next decade of stock returns are well below long-term averages (as current high CAPE levels would suggest), then the resulting 30-year annualized returns (from around 2000 to 2030) will have been lower than any other 30-year period in history.
It’s tempting to look at these graphs and imagine a predictive pattern where annualized returns regularly reach similar peaks every 30 to 40 years or so. But that’s most likely due to “apophenia”, which is the human habit of detecting meaning in random information. It seems far more likely that these regular-looking peaks and troughs are mostly coincidental. Nonetheless, it’s safe to say that the current 10-year annualized stock returns aren’t uniquely high.
High Inflation Is Not Necessarily Bad for Stocks
At the end of last year, inflation hit highs close to 7%, a level not seen for nearly 40 years, which I wrote about here and here. And a common concern is that high inflation is bad for the stock market. I’ve written before that most data and analyses show that stock returns are neither positively nor negatively correlated with inflation. In such cases, statisticians say that the two variables are “uncorrelated”.
So, we shouldn’t expect that stocks will necessarily perform poorly during bouts of high inflation. Using Aswath Damodaran S&P 500 data going back to 1928 and Shiller inflation data, I selected all years with inflation rates greater than 4% and plotted that against the same year’s real (inflation-adjusted) annual stock returns. Here’s the graph.
So, when inflation has been high, stocks have still produced positive inflation-adjusted returns 54% of the time, and they produced nominally positive returns 67% of the time. So, if history is any guide, continued high inflation is not a predictor of poor stock returns on either an inflation-adjusted or nominal basis.
Rising Interest Rates Aren’t Necessarily Bad for Stocks
Another common concern is that rising interest rates are bad for the stock market. Such worries are rampant right now because the Federal Reserve has telegraphed that they expect to raise interest rates multiple times, likely starting in 2022. However, Ben Carlson recently addressed this concern by finding all instances since 1950 where the yield on the 10-Year Treasury bond increased more than 1%. (He’s using the 10-Year bond yield as a proxy for interest rates, which is reasonable given that bond yields rise when base interest rates increase.) He then determined the nominal returns of the S&P 500 over each period of rising rates. I converted his data table into this graph.
Carlson concluded, “Over the past 70 years or so the stock market has done just fine in a rising rate environment.” While I generally agree, I couldn’t help but notice that larger rate increases often resulted in worse stock market performance over the same period. I calculated a negative correlation between bond yield increase and stock return in this plot at an R² value of about 0.32. This is a weak negative correlation, but not incredibly weak.
But in Carlson’s defense, most of the periods he examined were less than three years long, and in all but two cases nominal stock returns were positive over these relatively short periods. To me, this all suggests that interest rate increases may have a long-term dampening effect on the stock market, but increasing interest rates alone are unlikely to cause short-term stock market devastation.
Not All Stocks Are Expensive
You may have noticed that every comparison I’ve made so far is using S&P 500 data for “stocks”. The S&P 500 is composed of U.S. large-cap stocks, which are a good proxy for the entire U.S. stock market on a market-cap-weighted basis.
But you can invest in many other flavors of stocks. What if we instead consider non-U.S. stocks? Unfortunately, one of my best resources for global valuation measures is no longer online. So, I cobbled together some recent valuations for non-U.S. stocks from various sources.
Here are some CAPE Ratios from around the world as compared to the U.S.:
- U.S. – 39.6
- Global – 25.6
- United Kingdom – 14
- Europe ex.-UK – 23
- Italy – 25.9
- Spain – 18.3
- Australia – 19.9
- Japan – 22
- Emerging Markets – 15(!)
- China – 18.11
- India – 34.8
So, if you have a geographically diversified stock portfolio, your overall stock valuation is likely substantially less than a portfolio comprised entirely of U.S. stocks. For example, my stock portfolio is 60% U.S., 25% Developed Markets (ex.-U.S.), and 15% emerging markets. So, my dollar-weighted CAPE Ratio is more along the lines of 31.2.
Also, there are different flavors of U.S. stocks. I found a good report from Yardeni Research, Inc. that compares “Forward P/Es” of different kinds of U.S. stocks. (A Forward PE is like the Simple PE, but it looks at projected earnings estimates instead of recently reported earnings.) Here are some select Forward PEs from Yardeni starting with the S&P 500 as a comparative benchmark²:
- U.S. Large-Cap (S&P 500) – 20.8
- U.S. Mid-Cap – 15.6
- U.S. Small-Cap – 14.9
- S&P 500 Growth Stocks – 27.1
- S&P 500 Value Stocks – 17.2
First, note that mid and small-caps are considerably cheaper than large-caps. Second, U.S. Large-Cap Growth Stocks are particularly expensive, which pushes up the overall PE for the entire S&P 500. Put another way, value stocks continue to look like a bargain. Again, almost any diversification in your stock portfolio across these categories will likely lower the overall PE of your portfolio as compared to the S&P 500. The exception would be a heavy bet on growth stocks.
Conclusions
This post is not a prediction! I can feel the stock market falling even as I type, just to punish me for even attempting an optimistic post about stocks.
But the paradox of the markets is that they tell volumes about the feelings of everyone and nothing about the feelings of each investor. The markets don’t care what individuals like you and me think about them. They don’t care whether our hands are holding like diamonds or we just sold everything in a panic.
So, the only thing you should take away from this post is that, like almost every other moment in stock market history, you can come up with as many reasons for optimism as you can pessimism. Don’t let the growing doom and gloom noise from traditional media, and particularly social media, convince you of anything else.
1 – The Simple PE is more often called “Trailing PE” because it uses recent data, as opposed to the “Forward PE”, which uses estimates of future expected earnings.
2 – Don’t compare Forward PEs directly to Simple PEs or CAPE Ratios because that’s apples to oranges.
