Chart of the week: CAPEd crusader

Source: Robert Shiller (Yale School of Management), Aberdeen Standard Investments (as of May 2019)

 

While earnings growth drives long-term equity returns, investors must also look through the various lenses of market valuations if they are investing beyond a tactical time frame.

Different factors are important over different time scales when making investment decisions. How many years ahead are you really looking?

For those investors with a 10-year horizon, then valuations matter a lot. The cyclically adjusted price to earnings ratio, or CAPE ratio, is one such metric to be examined. The CAPE ratio is a valuation measure calculated by dividing price by average earnings per share over a 10-year period, after adjusting for inflation. The 10-year average is used to account for fluctuations in corporate profits or the business cycle, which is typically 10 years long (although the US economy is just about to complete a full 10 years of expansion). When the economy is doing well, consumers spend more money and profits tend to rise. During economic downturns and recessions, however, consumers buy less and profits fall or companies experience losses. The CAPE ratio irons this out, and allows the stock to be valued using a more sustainable earnings stream without all the cyclical noise.

Investors can use the information gleaned from a CAPE ratio to assess whether a particular security or, indeed, the entire stock market is overvalued or undervalued. Right now, the CAPE ratio of the S&P 500 Index is at elevated levels. In fact, it has only been higher once before – right before the tech bubble burst in the early 2000s. On the other hand, critics argue that because it is a backward-looking metric, rather than forward, it may be an unreliable indicator.

Over shorter time scales, such as a few years, then other drivers are usually more important. One is the risk of an economic recession, bringing about a collapse in corporate profits. A second is the cash flows generated by companies, and whether they can meet the needs of servicing debt and providing the dividend and share buybacks desired by investors. A third factor is investor positioning, is an asset class a crowded trade or deeply unloved.

On the basis of our broad analysis, then we think there are still opportunities to buy US equities on a tactical basis. The US economy looks able to grow moderately into 2020, delivering positive profits growth. Balance sheets are stretched in some sectors, but not across the market. In a world of low growth, corporate or economic, then the attractions of the superior growth of the US economy as a whole or key sectors such as technology and finance are highly regarded by investors.

RISK WARNING

The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.

The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.

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Risk warning

Risk Warning

The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.