Investing nerds, listen up…
I have some shocking news for you.
Before I get to it, if you are NOT an investing nerd like me, then you are welcome to skip today’s letter… No hard feelings.
However, if you have heard experts say things like, “Stocks have to crash soon because of the CAPE ratio,” then I urge you to read on. I have a revelation about this for you today…
To give you some context, the CAPE ratio is a widely quoted measure of stock market value. It is the “cyclically adjusted price-to-earnings ratio.” It was designed by Dr. Robert Shiller to give us a long-term look at stock valuations.
I’ll share today’s conclusion up front:
Stocks are actually trading at below-average valuations based on the CAPE ratio, when you look at earnings estimates going forward.
That’s an entirely uninteresting sentence for most people…
But it’s big news for us investing nerds. It will cause the minds of many academics in finance to blow a gasket.
Let me explain the basics…
The point of the CAPE ratio is to attempt to smooth out distortions caused by the business cycle. So it looks at 10 years of stock prices and earnings (along with inflation) – not just one year, for example.
Over the past 25 years, it’s done a reasonable job of smoothing things out and getting to the heart of the matter. For example…
- The CAPE ratio peaked at the end of 1999 – right around the stock market peak. And…
- It bottomed in March of 2009 – which is exactly when the stock market bottomed.
You can see these two points in the chart below:
The dot-com peak is obvious. And so is the 2009 bottom.
One other obvious thing is the trend of the CAPE ratio today. It’s going higher – fast. When investing nerds (like me) see it heading toward those dot-com highs again, most of them get very worried. Then, they draw a big conclusion… They say, “Crisis is imminent! The CAPE ratio says so.”
I would like to share an alternative view on this seemingly obvious conclusion…
(I call it an “alternative view” because roughly 100 out of 100 academics would likely disagree with me on this – but I hope they read what I have to say with an open mind.)
Here’s what I have to say:
My fellow investing nerds, the CAPE ratio is about to fall – dramatically – by the end of next year. (And that assumes no change in stock prices.)
If that happens, the CAPE ratio will be below its long-term average value going back to 1996.
Sounds crazy…
However, a couple things are about to happen to the CAPE ratio between now and the end of 2019 that nobody is talking about at all.
Keep in mind, what I’m saying has nothing to do with predicting stock prices… Stocks don’t have to do anything for this to happen. The CAPE ratio will fall dramatically even assuming stock prices are flat. (The “P” in P/E ratio is left unchanged.)
Instead, two interesting changes are on the horizon for the “earnings” part of the equation. (I’m talking about the “E” – the denominator in the CAPE.)
- Analysts estimate that the earnings number used in the CAPE ratio will skyrocket to a level of 163.1 at the end of 2019, versus the current number of 122.5.
- Bad earnings numbers from the Great Recession of 10 years ago, in 2008-2009, are about to fall out of the denominator of the CAPE ratio, pushing the denominator higher. That means the overall CAPE ratio will be lower, even with no change in stock prices.
That’s right… Higher earnings estimates are just part of it. The “secret helper” that will drive the CAPE down later in 2019 is simply the calendar.
By 2019, 10 years will have passed since the terrible earnings numbers from 2009. Removing a bunch of small numbers from the denominator (from 2009) and replacing them with large numbers (from 2019) will cause the denominator to get larger…
For example, earnings numbers of around 8 or so in early to mid-2009 will be replaced with earnings numbers like 153.9 in June 2019 (based on analyst estimates). That is, obviously, a massive difference.
Between soaring earnings and the “calendar secret,” the CAPE ratio is set to fall dramatically by the end of 2019… Far enough that could actually fall below its long-term average since 1996.
To show you this, I created a year-end 2019 estimate for the CAPE ratio. Here are the assumptions I used:
- No change in stock prices.
- Inflation of 2.3% at year-end 2019 (the consensus analyst estimate).
- Earnings that reach 163.1 at the end of 2019.
Under these conditions, take a look at what happens to the CAPE ratio by the end of 2019…
The CAPE ratio falls – dramatically – even assuming no change in stock prices.
And even if stock prices rise dramatically from here (as I expect they will during the “Melt Up”), these changes mean valuations will not start skyrocketing anytime in the near future.
That’s the really important part… You see, stock prices don’t actually have to fall soon at all. Stock market valuation is only a symptom at a top – it’s not a cause of the end of a bull market. And in any case, these estimates show stocks are not expensive today.
Well, that’s my story.
I’m still sure 100 out of 100 academics will have a problem with what I’ve said here… They have already decided that stocks are expensive because of the CAPE ratio… and therefore, stock prices must fall starting very soon. And there’s no changing their minds… at least for now.
Valuations look artificially high to some folks right now. That’s all going to change when these earnings changes kick in.
So, fellow investing nerds, what does this actually mean for you and your money?
I strongly believe we will see a dot-com style Melt Up before we see the big fall the academics are predicting. You ain’t seen nuthin’ yet…
Good investing,
Steve
Source: Daily Wealth