Coming up: five lean but volatile years: James Saft

July 24, 2014

July 24 (Reuters) – Even adjusting for extraordinarily low
interest rates, global equities are expensive and finding
double-digit annual real returns over the next five years is
going to be tough.

What’s worse, key markets, notably the U.S., are so
overpriced that there is a high likelihood of an upcoming
correction, according to a new study by Joachim Klement and
Oliver Dettman of economics and investment consulting firm
Wellershoff & Partners. (here)

The results should give pause to all who think that going
along for a central-bank-underwritten ride in the equity markets
is always a good idea.

“We show that high valuations like those currently recorded
actually lead to lower expected future returns and to increased
risks of significant drawdowns, including possibly permanent
loss of capital,” the authors write.

“To be clear, today’s high valuations are an alarm bell for
the future that investors should take very seriously.”

The study looks at equity market valuations in 38 global
markets using two main approaches. The first is by using a
cyclically adjusted price-to-earnings ratio, often called CAPE
or a Shiller P/E, which is like a straight P/E but which uses
average company earnings over 10 years adjusted for inflation.

The second is to do an adjusted ‘fair’ CAPE which takes into
account economic conditions like interest rates, growth and
inflation. That’s crucial because it allows us to see through
the effects of tepid growth and extraordinary monetary policy to
get a better sense of where stocks are and what history suggests
may be next.

For the U.S., CAPE is now at 24.5 which is 37.6 percent
higher than a ‘fair’ economically adjusted CAPE at a still
chunky 17.8.

That implies a real risk of a correction over the next five

“In the United States, when the CAPE has been at levels
comparable to today’s, the average drawdown over the next five
years has been an eye-watering 26 percent,” according to the

Of course those corrections range from the 80 percent
suffered after the crash of 1929 to 1995 and 2003 when the
following five years brought no correction of 15 percent or more
(though of course the great financial crisis began in 2008).

That’s the rub for investors now. Overvalued stocks may be,
but there is no promise that corrections arrive on any
timetable. One difference between now and the pre-1997 period is
that central bankers are far more prone to supporting falling
markets than capping rising ones. Remember too that a lot of
committed equity skeptics lost their jobs as money managers just
before the 2000 and 2008 corrections.


Those high U.S. valuations don’t just bring with them a high
risk of correction, they also imply quite low returns over the
coming five years, with the study predicting a 1.4 percent
annual gain in real terms.

Taking a broader look, things look a good deal better.
Global developed markets should return 7.5 percent on a real
(inflation-adjusted) basis over the next five years, and global
emerging markets 6.6 percent.

That’s not fantastic, but could be a lot worse.

Highlights include India, which should return 10.5 percent
on a real basis, and Italy and France, which should do just
about as well.

While this time always can be different, CAPE is a good
guide to future returns because markets historically revert to
mean. The authors show that correlations between the CAPE and
future five-to-10-year equity market returns are usually higher
than 0.7 in almost all covered markets.

If anything, one concern is that the earnings part of the
CAPE calculation is now very high, with earnings in recent years
at or near all-time peaks as a percentage of GDP. That may well
be a permanent change, perhaps due to the effects of
globalization on wages and production costs.

But earnings can revert to mean in the same way that the
price investors are willing to pay for them can. A small change
could have a big impact.

Writing earlier this year James Montier of fund mangers GMO
showed how if you use 10-year trend earnings rather than
trailing 10-year earnings the P/E of the U.S. stock market rises
to a teeth-aching 34 from about 25.

Neither main conclusion – that we may well have a correction
over the next five years and that returns will be moderate
(well, lousy in the U.S.) – is hugely surprising.

It does make it hard to be committed to being overweight, or
even equal weight an asset like U.S. equities which will barely
beat inflation and carries with it a sizable risk of meaningful
losses and volatility.

The arguments for international diversification get stronger
seemingly every day.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at and find more columns at

(Editing by James Dalgleish)

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