Stocks Are More Expensive Than They Used to Be

I used to write a lot about the CAPE ratio. It was a big topic of debate for a few years back in the mid-to-late teens. For those who weren’t around or are unfamiliar with this, it stands for the Cyclically Adjusted Price-Earnings ratio, and it inflation adjusts the last ten years worth of earnings to smooth out the volatility of the business cycle. All else equal, a lower ratio is good for high future returns, and the opposite is used to be true.

When I was writing about the CAPE ratio, it was as high as it had been outside of the run up to the Great Depression and the Great Financial Crisis. Gulp.

I gave several reasons why I thought a high CAPE was justified, and that just looking at the number without context was not the right approach. I’ll admit that I was pretty nervous taking a stand against all the academics and luminaries of our industry who were on the other side of the argument. Surely they knew more about investing than I did? To be clear, they do, and they did. But they were wrong and I was right.

One of these investors was Rob Arnott, who I had and still have an enormous amount of respect for. In January 2018, they wrote an article, CAPE Fear: Why CAPE Naysayers Are Wrong. The article featured yours truly.

I had mixed emotions when they published this. I was nervous that I would look back on this in embarrassment years later. But I also felt damn proud that they thought I was worthy of being quoted. Rob Arnott is a real one, and Research Affiliates is a no-joke asset manager.

It’s hard to believe seven years have passed since this article. It’s harder to believe that the S&P 500 is up almost 100% since their article came out, and delivered the highest 7-year performance for any CAPE starting at 33x. I did not see this coming. At all.

My whole thing was, yes, valuations are high. But companies are better today and deserve the premium multiple. I was not saying that a high CAPE is bullish. In fact, I ended most of my posts on this topic with the message of, “Expect lower returns.” I’ve never been happier to be wrong.

I want to return to some of the arguments I made, and what the CAPE zealots missed.

To use a long-term average that goes back to the late 1800s is foolish for three reasons. First, we didn’t have CAPE data back in 1929. It was first “discovered” in the late 90s. The discovery of data in financial markets changes the very essence of it. Markets are not governed by the laws of physics. They’re alive. They adapt and evolve and adjust, like an micro organism.*

Second, the CAPE ratio has been rising over time since the 1980s. We’ve only visited the long-term average once in the last 25 years, and that was at the bottom of the GFC. If that’s what it takes to return to the long-term average, maybe you should reconsider what an appropriate comp level really is.

Third, and most important, the companies are far better today than they were in the past. Here’s proof from JPM’s Michael Cembalest.

This next chart shows the profit margins of the S&P 500 going up and to the right. It seemed implausible in 2017 that this would continue to increase. But that’s just what happened.

Finally, here’s another one that shows how different today’s market is from the 1980s, when CAPE was in the single digits. About 60% of the S&P 500 was in manufacturing back then. Today its ~15%. Technology companies, with higher margins and larger moats, have taken their place. These are not the same businesses, and investors are rightly treating them that way.

Lest the timing of this post age very poorly, I realize that the CAPE ratio is at an eye-watering 37x. Seriously, and I mean it this time, lower your return expectations. If I’m wrong again, awesome. If I’m right, well at least you won’t be disappointed.

*I’m not a scientist. Sounded right.