The cyclically adjusted price-earnings (Cape) ratio is an excellent predictor of long-term equity returns, not only in the US, but also across the world, say Rob Arnott, Vitali Kalesnik and Jim Masturzo in a note for Research Affiliates. It takes into account earnings over ten years, thus smoothing out the ups and downs of the business cycle. The higher the Cape – the more expensive your starting valuation – the lower your long-term returns. Today the US Cape is flashing red. It’s reached 32, a level surpassed only during the bubble of 1929 and the technology bubble in the late 1990s. The long-term average since the 1880s is around 17.
Whenever the Cape is high, strategists come up with all sorts of explanations for why a higher Cape is potentially justified, and thus perhaps not necessarily a sign of poor long-term returns. Cape sceptics point out that the measure has been unusually elevated since the turn of the century, averaging about 26. One argument is that there has been a structural change in corporate profitability, justifying a higher Cape.
An increase in profit margins and the share of corporate profits to GDP have been notable features of the past decade or so. Globalisation has given US corporations a boost, trade-union power has receded, while lower interest and higher leverage have juiced earnings. The past two decades have also seen a decline in macroeconomic volatility, thus justifying an equilibrium Cape of 23.
Neither of these ideas are terribly convincing, says Research Affiliates. It’s far from clear that profits have reached a permanently higher plateau, justifying a higher Cape. Profit margins and earnings as a share of GDP revert to the mean. “We are sceptical that earnings can grow much in the years ahead, relative to GDP, without causing a populist backlash”, especially given years of stagnant real wages. Also note that real S&P 500 earnings peaked in 2014, so the earnings upswing may already be over.
Expensive on any score
Even if lower volatility is permanent, it does not justify a Cape of 32. And markets outside the US are nowhere near US levels. The sceptics also ignore the fact that a shrinking workforce, implying slower profit growth, is an argument for a lower equilibrium Cape. “Those offering eulogies… for the Cape ratio are premature – as has been the case repeatedly in the past.”