November 23, 2021

Chart of the Week: Valuations and returns – a (less) cautionary tale

by Fathom Consulting.

The cyclically adjusted price-to-earnings ratio (CAPE) for the S&P 500 is often used to illustrate the excessive valuations of equities, especially recently. However, CAPE does not control for the increasing importance of the level of interest rates for valuations. The excess CAPE yield (ECY) does so by taking the inverse of the CAPE (i.e., profits paid for each invested dollar) minus the inflation-adjusted ten-year Treasury yield. Effectively, the ECY reflects the yield margin that investors demand to hold stocks instead of bonds. Can the ECY tell us something about future returns? We find the ECY is positively related to future returns. When the ECY sits at around 3%, the historical median, the subsequent average ten-year return for equities is between 4% and 15%. While the latest value is slightly below the median, equities are still expected to beat bonds, because of low rates and returns from holding bonds. So, despite the risks highlighted by other metrics and the high CAPE, equity valuations may not be too absurd, according to the ECY. However, the ECY has been pointing to lower and lower future returns. It has dropped from 3.7% in 2020 Q3 to the latest value of 2.6% as the S&P has soared. If monetary policy tightens to control inflation, bond yields could rise, and fixed income would start paying more, and equity’s edge would shrink.

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