Lessons from History
In amongst all the talk of Bitcoin (insert here any other phrase here such as Tulip Mania, South Sea Bubble, Nifty Fifty, Technology, Long Term Capital Partners, Mortgage Backed Securities) and its incredible rise in value over the last few years stock market investors are still not paying attention to their history books! The Cyclically Adjusted Price Earnings Ratio (CAPE) is a well know method of gauging under or over valuation in the Stock Market; typically the US is used as an example as monthly data back to the 1880’s is available.
This ratio adjusts earnings for inflation and looks at an average of 10 years, hopefully ironing out any temporary rise or decline in them over a business cycle; the price of the stock market is then divided by the earnings to give a price earnings ratio – if the share price is £20 and earnings were £1.30 you the price ratio would be 15.4x (£20/£1.30) effectively you are paying for earnings for the next 15.4 years.
The long term average of the CAPE for the US S&P 500 is 16.8x; however, at present it trades at a significantly higher level – in fact it has only ever been higher twice before, prior to the Wall Street Crash and prior to the bursting of the Technology Bubble.
Using the information that we have on dividends, earnings growth and the average CAPE we can then start to build a model of prospective returns based on a fairly simple equation
Prospective Annualised Returns over the next 7 Years = Dividend Yield + Earnings Growth + Reversion to Average CAPE over next 7 years
So, if we know the current dividend yield is 1.5% and that earnings growth has risen on average by 4% over time we can estimate prospective returns at 5.5% per annum; however we also need to consider the final part of the equation and how the CAPE will revert to its average over the next 7 years – again this is fairly simple if the current CAPE is 20 and the long term average 16.8 over the next 7 years it will result in a loss of 19% (20/16.8-1) which annualised is -2.46%. Putting this all together we then get a prospective return of 3.04% per annum. Applying this to the data we have using the median earnings growth since 1881 of 4.86% and the average CAPE of 16.81x you can see that it builds a pretty effective model of potential future returns from the US S&P 500 Index – we are now looking at prospective returns of -1.78% p.a. for 7 years.
On this day
8th December 1864 - The opening of the Clifton Suspension Bridge over the River Avon at Bristol, designed by Isambard Kingdom Brunel when he was aged just 24. A plaque on the bridge commemorates Brunel’s work.
