Shiller’s CAPE won’t save you, saving will

February 18, 2015

Feb 18 (Reuters) – Even when it is coming from a Nobel Prize
winner, the simplest financial advice is usually the best.

When economist Robert Shiller said on Wednesday he was
considering “getting out of the U.S. somewhat” it quite rightly
made headlines.

After all, this is the man who helped create the cyclically
adjusted price-earnings (CAPE) ratio, sometimes called the
Shiller P/E, which is now in the kind of nosebleed territory
only seen twice before: just before the dotcom and 1929 crashes.

If he is lightening up on U.S. shares it is right to take

Shiller went on to talk about the attractions of peripheral
euro zone stocks, in Spain and Italy, as alternatives.

Rather than making a market call and then looking for a
trade, I’d argue that it is what Shiller said next which is his
best guidance:

“You have to save more; unless you have some special idea,
realistically you are not going to get the same returns,”
Shiller told CNBC Television.

There, in a nutshell, is the current situation: bet on your
ability to find gold among the dross or tighten your belt.

The big insight here isn’t that the U.S. is too expensive
and therefore Italy, or energy exploration companies, or
something, is a better bet. The big realization is that if asset
markets are expensive, as they appear to be, than you had better
scale back your expectations for future returns. They may be
quite poor taking today as a starting point.

Saving more is a simple, elegant, if perhaps painful way to
insure against that.

CAPE p/e is a simple concept: divide share prices by the
average of 10 years’ earnings adjusted for inflation. As of
today the CAPE P/E for the S&P 500 stands at 27.52. This
compares to a 44 reading in December 1999 and about 30 just
before Black Tuesday in 1929.

A note of caution: because companies these days favor
buybacks, which flatter EPS, over dividends, it may be that CAPE
isn’t measuring the same as it has in the past.


Still, if we compare the CAPE P/E of today with the historic
mean of 16.58, the market is expensive. And if you expect that
P/E to revert to mean over the next eight or 10 years you will
very likely see average annual returns in the very low single
digits. May not happen, but worth insuring against.

The correlation between stock valuation and future returns
over the short term is low, only about 20 percent over one year,
according to calculations from fund manager GMO. Over 10 years,
however, the correlation is 60 percent.

And where you start out has a huge impact. In a 2014 study
( Ben Inker and Martin Tarlie of GMO consider
the plight of a worker who turned 55 in 1965, at which point she
was on target for retirement savings.

“The worker, however, had the misfortune of being in peak
savings years during a period in which equity valuations were
high and real bond yields were low. The period from the
mid-1960s through the 1970s represents some of the worst real
returns for both stocks and bonds on record.” Inker and Tarlie
write. High equity valuations and low yields. Sound familiar?

The result: if our worker takes a 5 percent yearly payout in
retirement she will most likely be broke by 1992, at age 82.

While Inker and Tarlie argue for dynamic allocation taking
into account valuation, which may well be useful, saving more
has some great advantages as a strategy in current
circumstances. The thing about investment strategies is that
they all employ the time value of money, meaning that the most
important gains come down the line from compounding. That’s
true, but those gains are speculative, in that we never know
ahead of time what our actual experience will be.

A dollar saved today, however, has a realness and solidity
not enjoyed by prospective returns tomorrow. Unless you go in
for Ponzi schemes you can be sure that all of the money you save
today will improve your situation in the future. The same cannot
be said for strategies, no matter how clever.

It seems to follow then that the more uncertain you are
about future returns the more you should save.

The very high CAPE P/E is a source of uncertainty. Things
may well be different this time. Equities may well have a great
next decade. Perhaps not.

Saving, as Shiller recommends, is probably your best hedge.
(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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