The Upward Drift

Cliff Asness is out with a new interesting paper, “Market Timing Is Back In The Hunt For Investors.” In it, he discusses the efficacy of using valuations, specifically the CAPE ratio, to help time the market. One thing Asness addresses is the valuation drift upward which U.S. stocks have experienced over the last century.

Here’s Cliff:

“As alluded to earlier when discussing the long-term upward drift in CAPE, another related but distinct headwind for contrarian stock market timing in the second half of our sample has been the decades-long valuation drift in post-World War II equity markets, over which the CAPE gradually doubled. The average CAPE for the decade immediately following WWII was 12.4, while the average CAPE since the year 2000 has been over 25.”

He then addresses the oft-heard argument that this valuation drift is a secular change.

“There’s always the additional risk that these secular changes are not just random wanderings, which will eventually work themselves out, but justified permanent changes in levels. That is, perhaps the CAPE is higher, but we should never expect it to go back to historical levels. This is a well-known ‘the world has changed’-type argument. While we tend to be natural cynics, as these arguments abound and are often wrong, they certainly can’t be dismissed.”

I do think there is some validity in the argument that stocks deserve a higher multiple today then they did at the turn of the 20th century. To understand why, let’s go back and look at America’s first billion dollar corporation, U.S. Steel. In 1902 they employed 168,000 people and had sales of $561 million. In today’s dollars, that’s ~$15.1 billion.

One of the reasons I believe we’ve seen an upward drift in valuations is because of the improvement in efficiency and productivity. Today, 175 S&P 500 companies have more revenue than $15.1 billion. In 1902, U.S. Steel had $3,340 in revenue per employee, which is $90,000 in 2014 dollars. Today, U.S. Steel’s revenue is $493,000 per employee, 5.5.x the amount it was in 1902.

Of the 52 S&P 500 companies that make this metric readily available, only one has sales per employee less than $90,000.

sales per emp

Not only has productivity vastly improved, but many of the frictions of trading have disappeared. Today, you can buy $100 million dollars worth of the S&P 500 with the push of a button and nobody would notice.

Along with improved productivity and trading execution, accounting standards have been a game changer. For much of the long-term CAPE averages, investors had little idea about a company’s actual financials. How much would you pay for $1 of suspected earnings when accounting laws didn’t exist?

With millions of Americans shoveling money into their retirement plans every month, there is a much greater demand for stocks than their was in the first half of the twentieth century. In roughly half of the long-term CAPE ratio, mutual funds, which brought stock investing into the main stream, didn’t even exist.

To be sure, I don’t think it’s impossible that we never see single digit valuations again, who could be so sure of such a thing. But getting back to the question of whether you can time the market based on valuation, I think that’s extraordinarily difficult. Consider that over the last 25 years and 925% return, stocks have been above their long-term CAPE average for 293 out of 309 months. While higher valuations absolutely do mean lower future returns, it’s all but impossible to know when to expect them.

When stocks look pricey, the best thing for most people to do is adjust their expectations accordingly. Making a habit of going in and out based on valuations is probably not going to help you build your wealth.

This content, which contains security-related opinions and/or information, is provided for informational purposes only and should not be relied upon in any manner as professional advice, or an endorsement of any practices, products or services. There can be no guarantees or assurances that the views expressed here will be applicable for any particular facts or circumstances, and should not be relied upon in any manner. You should consult your own advisers as to legal, business, tax, and other related matters concerning any investment.

The commentary in this “post” (including any related blog, podcasts, videos, and social media) reflects the personal opinions, viewpoints, and analyses of the Ritholtz Wealth Management employees providing such comments, and should not be regarded the views of Ritholtz Wealth Management LLC. or its respective affiliates or as a description of advisory services provided by Ritholtz Wealth Management or performance returns of any Ritholtz Wealth Management Investments client.

References to any securities or digital assets, or performance data, are for illustrative purposes only and do not constitute an investment recommendation or offer to provide investment advisory services. Charts and graphs provided within are for informational purposes solely and should not be relied upon when making any investment decision. Past performance is not indicative of future results. The content speaks only as of the date indicated. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others.

The Compound Media, Inc., an affiliate of Ritholtz Wealth Management, receives payment from various entities for advertisements in affiliated podcasts, blogs and emails. Inclusion of such advertisements does not constitute or imply endorsement, sponsorship or recommendation thereof, or any affiliation therewith, by the Content Creator or by Ritholtz Wealth Management or any of its employees. Investments in securities involve the risk of loss. For additional advertisement disclaimers see here: https://www.ritholtzwealth.com/advertising-disclaimers

Please see disclosures here.