We update our long-term 10-year forecast for the first quarter of 2021, and in this report, we present our 10-year forecasts for equity benchmarks in the United States, Europe and Japan.
The Cyclically Adjusted Price Earnings (CAPE) Ratio is a long-term market valuation metric that averages 10 years of inflation-adjusted earnings. This allows a long-term view of valuations, unlike the PE ratio that uses one year’s worth of earnings. The CAPE Ratio was developed by Robert Shiller and John Campbell in the late 1980s for forecasting 10-year equity market returns.¹ The CAPE Ratio is best used as a long-term forecasting tool and in this report, we utilize it to project 10-year expected returns.
Q2 2021 Review
Markets experienced a strong quarter with the S&P 500 Index leading the way with a gain of 6.2%, Europe saw gains of 4.2% and Japan gained 1.7%. In the US, the CAPE ratio exceeded 36 making the stock market quite expensive. That is evident when you compare current stock valuations with those from previous eras, for example, the average in the CAPE Ratio in the last 20 years is around 25, since 1871 it is 17. But it is also true that stock prices though high are not unreasonable right now. That seemingly contradictory conclusion arises when you include other important factors: interest rates and inflation, which are both extremely low, showing that alternatives to the stock market have low expected returns too.
The CAPE ratio in the US is 36.6 as of mid-April, still much lower than its highest level, 45.8, which was reached on March 24, 2000, at the peak of the millennium stock market boom. The CAPE Ratio for Europe is 22.8 (20.8 last quarter.) In Japan, the CAPE Ratio is 24.3 (22.8 last quarter).2 CAPE Ratios are stretched however these may be somewhat justified by low interest rates and inflation figures.
We developed a metric called the ECY to quantify the attractiveness of equities over bonds. During the March 2020 pandemic, the ECY reached highs not seen since 2009 or 4 decades previously, indicating that equities were highly attractive.3 This metric, and hence the attractiveness of equities, has come down somewhat recently as bond yields rose over the quarter.
For those overexposed to equity risk, selling some stocks now in favor of bonds might be worthwhile. Treasuries, for example, are highly likely to retain their nominal value. In a time of stable inflation, they are generally safer than stocks. Annuities may also form part of a stable portfolio with their longevity protection. But for most people, a well-diversified portfolio containing both diversified stocks and bonds is generally a good idea. Moreover, stocks may be more attractive than bonds, because if the economy revives, fear of inflation may as well.
Key Findings: Our Forecasts based on the CAPE Ratio
The graph below highlights our 10-year annualized nominal forecasts using the CAPE Ratio for the three key regions. Europe and Japan have higher expected returns at 5.4% and 6.9%, respectively than the United States at 3.6%. Returns in the US are lower than those of the other regions as the CAPE is higher than it has been in the past. With this in mind, we recommend remaining diversified.
Source: Data Robert Shiller online data, MSCI and OECD.
A Note About Forecasting
These are long-term forecasts with a horizon of 10 years. These forecasts are intended to provide a framework and guide investors around strategic equity allocations. They are not intended for those seeking to time markets or obtain short- to medium-term forecasts, as short-term forecasts are unreliable. The forecasts are presented as nominal total annualized returns in local currencies and are presented as a guide only. The forecasts make no attempt to judge the impact of one of the kind transient factors like COVID-19, political changes, or monetary policy changes, not because these are not potentially important, but because we are not able to quantify them without guesswork.
United States – Forecasts Based on the S&P 500 Index
The CAPE Ratio for the United States is 36.6 and the expected 10-year annualized nominal total return is 3.6% Returns for the S&P 500 Price Return Index are expected to be 1.3 %; here we subtract the average dividends over the last 10 years. Professor Shiller created a series of value-based indices with Barclays, namely the Shiller Barclays CAPE Family of Indices, which seek to identify undervalued sectors or stocks using the CAPE Ratio. These indices aim to earn a long-term value premium. While past performance is not guaranteed, if an investor purchased a value-based index and held this for the long term, they may generate higher returns than forecast if the value factor performs.
Historical CAPE Ratio – United States:
Europe – Forecasts Based on the MSCI Europe Index
The CAPE Ratio for Europe is 22.8 and the expected 10-year annualized nominal total return is 4.3% as of the end of the 4th quarter. Price returns for the MSCI European Price Return Index are forecast to be around 2% when we subtract the historic dividend yield and assume this holds true for the next 10 years. Value-based indices such as the Shiller Barclays CAPE Family may generate higher returns than forecast if the value factor performs and if the index is held over the long term.
Historical CAPE Ratio – Europe:
Japan – Forecasts Based on the MSCI Japan Index
The CAPE Ratio for Japan is 24.3 and the expected 10-year annualized nominal total return with the CAPE Ratio is 6.3%. Price returns for the MSCI Japan Price Return Index are forecast to be 4.4%; again we subtract the historic dividend yield and assume this holds for the next 10 years.4 A value-based index such as the Shiller Barclays CAPE Family may generate higher returns than forecast if the value factor performs and if the index is held over the long term. Note our forecasts include the bubble period in Japan in the 1980s and this may overstate some of the numbers.
Historical CAPE Ratio – Japan:
Approach to Forecasting
We outline our approach to forecasting in this section. First, we predict the expected returns based on the CAPE Ratio, as developed by Robert Shiller and John Campbell in their paper “Stock Prices, Earnings and Expected Dividends.”5 To generate the forecast, we take the prevailing CAPE level and regress this against long-term data sets and project returns based on the line of best fit.
Professor Shiller noted that returns are influenced both by the CAPE and an estimated real long-term interest rate in the 3rd Edition of Irrational Exuberance. Given that interest rates are unusually low by historical standards, we also produce a third forecast of excess equity returns over bonds where we regress excess equity returns, the CAPE Ratio as well as the prevailing level of interest rates. Some commentary has noted that higher CAPE Ratios may be justified by low rates. Given the low level of interest rates, this is an important facet to consider.
1 The CAPE Ratio was developed by Robert Shiller and John Campbell in the late 1980s for forecasting 10-year equity market returns. John Y. Campbell and Robert J. Shiller, “Stock Prices, Earnings and Expected Dividends,” Journal of Finance, 43:3, 661-76, July 1988.
2 The CAPE Ratio history for Japan includes the Japanese bubble period in the late 1980s; thus when forecasting using the lower Japanese CAPE Ratio, forecasted returns may be elevated, as the sample includes this bubble period.
3 The ECY is defined as the difference between the reciprocal (or the inverse) of CAPE — that is, 10-year average annual real earnings divided by real price — and the real long-term interest rate.
4 The CAPE Ratio history for Japan includes the Japanese bubble period in the late 1980s; thus when forecasting using the lower Japanese CAPE Ratio, forecasted returns may be elevated, as the sample includes this bubble period.
5 Source: John Y. Campbell and Robert J. Shiller, “Stock Prices, Earnings and Expected Dividends,” Journal of Finance, 43:3, 661-76, July 1988.
DISCLAIMER: Any past or simulated past performance including back-testing, modelling or scenario analysis contained herein is no indication as to future performance. No representation is made as to the accuracy of the assumptions made within, or completeness of, any modelling, scenario analysis or back-testing. All opinions and estimates are given as of the date hereof and are subject to change. The forecast of any return may also fluctuate as a result of market changes. The authors are not obliged to inform the recipients of this communication of any change to such opinions or estimates. This paper represents the opinion of Robert J. Shiller, RSBB-I, LLC, and its consultant, IndexVestLAB, LLC and consultants thereto. It is not intended to be a forecast of future events, a guarantee of future results or investment advice with respect to any securities or other investment products. The presentation should not be deemed an offer or sale of any securities or other investment products and should not be relied on for such purpose. This presentation should not be distributed to any person other than the intended recipient. The user of this information assumes the entire risk of any use made of the information provided herein. Professor Shiller is the Sterling Professor of Economics at Yale University and Fellow at the International Center for Finance, Yale School of Management. None of Professor Shiller, Yale University or any other party involved in making or compiling any of the information included in this presentation, makes any express or implied warranty or representation with respect to its content, form or any use thereof.