Site Visitor to Rob: “The Shiller CAPE Ratio Provided a Fairly Accurate Forecast of 10-Year-Ahead Returns—for a While. Since the Mid-1990s, However, the Predictive Power of This Metric Has Deteriorated.”

Set forth below is the text of a comment that I recently posted to the discussion thread for another blog entry at this site:

Here’s some new research, which you claim to always be interested in. The “fair-value CAPE”:

https://investornews.vanguard/valuing-the-stock-market-with-a-new-yardstick-the-fair-value-cape/

“As the figure below illustrates, the Shiller CAPE (cyclically adjusted price-to-earnings) ratio provided a fairly accurately forecast of 10-year-ahead returns—for a while. Since the mid-1990s, however, the predictive power of this metric has deteriorated.”

Specifically, the chart shows that Shiller’s results fall apart starting in 1996. Seems like that’s a significant year, but I can’t remember why. Anyway, the fair-value CAPE, which has smoked Shiller since then, is not predicting a crash. It says only that the market is somewhat overvalued.

Good news, right? You’re not really hoping for a crash are you? That would be ghoulish.

Thanks for the link.

The predictive value of the metric has deteriorated for a time because the insane level of mispricing which came into effect in 1996 has not yet resolved itself. Assume that stocks return to fair-value prices tomorrow and re-run the numbers and you will obtain very, very different results.

If stock prices are determined by a rational process, then there is no need to re-run the numbers. But, if stock prices are determined primarily by shifts in investor emotion, then it is absolutely imperative to do this. So the core question is — Are stock prices determined by economic realities or by shifts in investor emotion?

The way to test this is to check whether prices fall in the pattern of a random walk or not. If prices fall in the pattern of a random walk, it is reasonable to conclude that it is economic realities that are causing price changes. And, in the short term, we do indeed see a random walk. But in the long term, we do not see a random walk. In the long term, valuations affect long-term returns. Why? Because it is investor emotions that determine returns and valuations measure the extent of investor emotion present at various points of time. That’s what Shiller showed with his “revolutionary” (his word), Nobel-prize-winning research of 1981.

It would be very, very, very good news if there were a way to avoid another crash. I will certainly give you that one. If if it true that valuations affect long-term returns, the only way to avoid crashes is to educate investors as to the realities we have learned over the past 37 years. Stock prices are self-regulating so long as honest posting is permitted at every internet site. High prices equal low long-term returns and investors who are aware that long-term returns are going to be low sell stocks, which brings prices back to reasonable levels. Stock markets in which investors are not able to learn what the last 37 years of peer-reviewed research teaches us are runaway trains. It is price discipline that keeps markets functioning properly. Buy-and-Holders rule out any possibility of ever exercising price discipline when they make their first stock purchase. Not good (if the last 37 years of peer-reviewed research is legitimate research, which I believe it to be).

Ghoulish (But Only If Buy-and-Hold Remains Unchallenged for Too Much Longer) Rob