Follow the Man with the CAPE
Q It was the best of times, it was the worst of times … Though the context is different from Charles Dickens’ magnificent work A Tale of Two Cities, its prelude accurately describes the past year. The coronavirus pandemic left people throughout the world in despair. Draconian measures to curb the virus froze economic activities and forced millions of people out of jobs. Countries went into recession; some still haven’t emerged.
On the other hand, after a massive plunge in March when lockdown measures stretched around the world, many stock markets recovered in a V-shaped manner. Some are continuing to rally, undeterred by surging infections and new lockdowns.
There are explanations for this market behaviour. First, the market advance continues because investors have already looked ahead, beyond the pandemic. They see the light at the end of the tunnel. Valuations are rising because investors started to price in the recovery phase. Though the pandemic is raging in many countries, vaccine distribution is buoying sentiment. The SET Index, for instance, saw only a minor drop when the country entered a second wave of the pandemic. It rebounded quickly afterward.
Extremely low interest rates is another reason for the market’s bullish trend. Real yields — the bond return after adjusting for inflation — plunged all over the world due to the current accommodative environment. The fall in real yields, in turn, makes stock prices more appealing for investors.
Q The logic lies in Nobel Laureate Robert Shiller’s concepts of cyclically adjusted price-to-earning (CAPE) ratio and his extension the Excess CAPE Yield (ECY). The CAPE ratio captures the ratio of inflation-adjusted share price to the 10-year average of real earnings per share. Historically, when the market is bull, the CAPE ratio is usually high. And long-term returns over the next decade tend to be low. Data reveals the CAPE ratio for the S&P500 is at 33.73 in January, the highest level in the last two decades. The ratio in other markets such as China, Europe and Japan are also higher than they were before the pandemic.
Q If history could suggest the future, then the markets should probably have low returns for the next decade or so. However, this is an unprecedented time. That is why the extensive part of CAPE ratio — the ECY — should be used instead. The share price in the CAPE ratio, like a normal P/E ratio, is calculated using the discounting method. A lower interest rate causes the present value to increase, according to modern theory of finance, which translates into a higher share price and CAPE ratio.
Q Instead, the ECY captures both equity valuations and interest rate levels by inverting the CAPE ratio and then subtracting the 10-year real interest rate. The ECY captures the equity market premium because it measures the difference between real yield in the market and real bond yield. The higher the ECY gets, equities are relatively more attractive than bonds.
Q For instance, the ECY in the S&P500 is at 3.63%. Meanwhile, the ECY in other countries such as the UK and EU are even higher. The key point of the ECY is it does confirm that one of the contributing factors to the stock rally is the relative attractiveness of stocks to bonds. Our calculation reveals this is also true for the SET Index. Although the index return in 2020 was -8.26%, the ECY for the SET Index is 4.53%, around the same level as the S&P500 and the euro zone.
Q We do not argue the excess yields in these markets should be a major reason to invest in these assets. We are merely trying to explain there is some sense in the current market run-up, but there are also key risks that could stop the ascent. First, investors have been making valuations assuming the vaccines are effective and the post-pandemic world will arrive soon. But if the recovery takes longer than expected, it is possible the bull run could vanish. Ineffective or insufficient fiscal policies could add to the downside risks of economic recovery. Finally, pent-up demand together with supply shortages could be a risk towards resurgent inflation in the short run, which could trigger the central banks to raise rates.