Summer Quarterly Commentary

“It is difficult to make predictions, especially about the future.” - Danish Proverb

Since we are necessarily in the predictions business, this letter offers our expectations for equity market returns. We admit our crystal ball is typically cloudy when it comes to what markets will do in the near term. While nothing is ever for certain, we can better view the potential for longer-term stock market returns from a couple of perspectives. We attempt to form an idea about future long-term returns first by using cyclically adjusted earnings and then by using a framework articulated by Warren Buffett years ago.

The cyclically adjusted price-to-earnings ratio (CAPE ratio) is the best predictor we know of when it comes to long-term equity returns1 . Forget for a moment how it is calculated and just know that it is basically a measure of market expensiveness. This measure is often misunderstood and misused. It does not identify market tops or bottoms or tell us what will happen tomorrow or next year – it has no bearing on these topics. The CAPE ratio has really just one useful application: giving a sense of the next ten years’ stock market returns. This is accomplished by going back in time, seeing what the CAPE ratio was at that time, and seeing also what the stock market actually returned for the next ten years (including dividends and adjusting for inflation). When these two measurements (the historical CAPE and subsequent ten-year returns) are plotted on a scatter plot, the relationship becomes obvious: the higher the CAPE the lower the returns2.

When the CAPE ratio has been similar to today’s 31.8 (as it was in 1929, 1997 and 20013 ), the S&P 500 Index delivered ten-year annualized returns, after inflation, ranging from +3.3% at best to -2.4% at worst, with an average of 0.8%. Yikes. Add 2% to 3% inflation to the “real returns” quoted above to get before-inflation “nominal returns” and you are supposed to have a good idea what the stock market may deliver annually over the coming decade. There is no prediction involved here; this is simply what has happened in the past when the market was similarly expensive according to the standard CAPE measure. And yet, we think there are some reasons that using this measure might not be ideal, and the future might not be so bleak.

So what is the CAPE measurement? It’s simply the ratio between the price of the market today, and the average earnings of the market for the past ten years4. This is the same as the standard P/E ratio (price divided by earnings) except that the CAPE uses ten years of earnings for the denominator while the standard P/E only uses one year’s worth. Why do we care about earnings generated five or ten years ago? Directly, we don’t. What we do care about is future earnings, but the idea here is that the past can tell us something about the future. If we are looking at the past to tell us about the future, the creators of the CAPE5 recognized that looking at shorter periods (say the last one or three years) can be misleading because corporate earnings fluctuate quite a bit. In a given year, earnings might be higher or lower than “normal”. The idea is to look back at enough years of history which should contain different parts of the earnings cycle to “smooth” earnings and help us gain a representative idea of what the future should be like, not just for a year or two, but all through the business cycle. This way, high CAPE ratios should arise from high stock prices, and not from temporarily low earnings.