By Robert J. Shiller, and Laurence Black, and Farouk Jivraj
NEW HAVEN, Conn. ( Project Syndicate )—There has been much puzzlement that the world’s stock markets /zigman2/quotes/210599714/realtime SPX +1.95% /zigman2/quotes/210599024/realtime GDOW +0.48% /zigman2/quotes/210598065/realtime DJIA +1.85% haven’t collapsed in the face of the COVID-19 pandemic, and especially in the United States, which has recently been setting record highs for new cases.
But maybe it isn’t such a puzzle. A measure we call the Excess CAPE Yield (ECY) puts the long-term outlook for the world’s stock markets in better perspective.
Indisputably, asset markets are substantially driven by psychology and narratives. As the Nobel laureate Daniel Kahneman wrote, “familiarity breeds liking,” and several familiar narratives have emerged in the world’s stock markets this year, following the initial COVID-19 shock in the first quarter.
For example, there is the V-shaped recovery narrative and the FOMO (fear of missing out) narrative; both might be helping to drive markets to new highs. There is also the work-from-home narrative, which has specifically benefited technology and communication stocks.
But are these narratives the only reason why all of us have not considered just pulling our money out of stocks and putting it into safer alternatives such as bonds, or even under the mattress at home?
The cyclically adjusted price-to-earnings (CAPE) ratio , which captures the ratio of the real (inflation-adjusted) share price to the 10-year average of real earnings per share, appears to forecast real long-term stock-market returns well in five influential world regions. When the CAPE ratio is high, long-term returns tend to be low over the next 10 years, and vice versa. Since the COVID-19 shock, CAPE ratios have mostly recovered to their pre-pandemic levels.
For example, the U.S. CAPE ratio in November 2020 is 33, exceeding its level prior to the start of the COVID-19 pandemic; in fact, it is now back to the same level as the high of 33 in January 2018. There are only two other periods when the CAPE ratio in the U.S. was above 30: the late 1920s and the early 2000s.
China’s CAPE ratio is also higher than it was prior to the pandemic. The stock markets in both regions are skewed toward the technology, communication services, and consumer discretionary sectors, all of which have benefited from the major narratives of the COVID-19 pandemic, which may partly explain their higher CAPE ratios relative to other regions.
As for Europe and Japan, their CAPE ratios are largely back at their pre-COVID-19 levels, while only the United Kingdom is still well below its pre-pandemic level and longer-term average. Notably, these regions have lower exposure to the technology, communication services, and consumer discretionary sectors.
Market observers have noted the potential role of low interest rates /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y +0.25% in pushing up CAPE ratios. In traditional financial theory, interest rates are a key component of valuation models. When interest rates fall, the discount rate used in these models decreases and the price of the equity asset should appreciate, assuming all other model inputs stay constant.
So, interest-rate cuts by central banks may be used to justify higher equity prices and CAPE ratios.
Thus, the level of interest rates is an increasingly important element to consider when valuing equities. To capture these effects and compare investments in stocks versus bonds, we developed the ECY, which considers both equity valuation and interest-rate levels. To calculate the ECY, we simply invert the CAPE ratio to get a yield and then subtract the 10-year real interest rate.
This measure is somewhat like the equity market premium and is a useful way to consider the interplay of long-term valuations and interest rates.
A higher measure indicates that equities are more attractive. The ECY in the U.S., for example, is 4%, derived from a CAPE yield of 3% and then subtracting a 10-year real interest rate of -1.0% (adjusted using the preceding 10 years’ average inflation rate of 2%).