Articles From Category “Research” 1

  • In the past 100 years, equity investors have managed to generate real capital growth of an annual average some 7 percent. No other form of investment – whether bonds, cash, gold or real estate - offers comparable return potential. But does it still pay to invest in equities at this point in time, and what returns can investors expect in the long term?

    The German equity index has more than doubled in price in the last five years since its low in March 2009. In 2013 alone, the DAX achieved more than 25 percent capital appreciation. Sad to say, hardly any investor participated in this. The latest BVI statistics document that German investors remained net sellers of equity funds in 2013 - withdrawing capital worth more than EUR 6 billion.

    The fact that investors frequently choose the wrong time to gain exposure or to exit is nothing unusual. But is it possible at all to identify lucrative buy opportunities or risks on equity markets in advance? The forecast quality of capital market experts gives reason for doubt. There is virtually no correlation between the market forecasts for the next year regularly published at year-end and the actual performance in that year. Even the question of whether shares prices are more likely to rise or fall in the following year appears virtually unanswerable. For example, in the crisis years 2001, 2002 and 2008 the most reputable credit institutions forecast price gains for the DAX in average terms of +20%, +12% and +5% respectively. However, the German equity index actually incurred extreme losses in these years of -20%, -44% and -40% respectively.

    Not only proponents of the theory of efficient capital markets doubt the significance of short-term equity market forecasts. Traditional economic models for evaluating future equity market potentials are frequently based on questionable assumptions. The common procedure of drawing conclusions on the earnings development of companies from the economic development of a country and estimating the equity market potential from the equity market valuation derived from this is doomed to fail: At best a rough forecast can be made of the economic development, with the earnings development of global players increasingly decoupling from the internal economic trend of their country and profit growth correlating only very weakly with the equity market development in the short to medium term.

    Furthermore, equity prices are determined in the short to medium term by unpredictable events. Terror attacks, the outbreak of war, oil price shocks, statements by central banks, currency crises as well as behavioral finance and herd effects influence short-term market happenings more strongly than calculable fundamentals. Three hundred years earlier, Newton already made the painful assertion that he „was able to calculate the movements of stars down to the very second but not the madness of men“.

    What Significance does the classic Price-Earnings Ratio (P/E) have?

    Hence, a meaningful connection between valuation ratios such as the familiar price-earnings ratio (P/E), which denotes the ratio of a market‘s corporate profits to the current market price and future equity market returns, couldn‘t even be established if it were possible to make a precise forecast of the next year‘s corporate profits. A further reason is that in recession years such as 2009 classic
    P/Es appear unattractive because the high or negative price earnings ratio resulting from the corporate losses does not factor in the companies‘ potential for earnings increases after the crisis.


    S&P 500 Index: Cyclically Adjusted Price-Earnings Ratio (Shiller-CAPE)



    Figure 1: Connection between CAPE and the inflation-adjusted S&P 500 Performance Index in USD in the period 1881-2013. The blue columns mark all
    the overvaluation phases in which the CAPE exceeded 24. Sources: Robert J. Shiller, StarCapital.



    However, many of the weaknesses of classic P/Es can be eliminated. Robert J. Shiller, winner of the Nobel Prize for Economics, was able to prove that inflation-adjusted corporate profits have achieved relatively stable growth on the American equity market since 1871 of 1.6% p.a.1. As above-average corporate profits in economically strong years are as short-lived over a long term horizon as high corporate losses in recession phases, he developed a cyclically adjusted price-earnings ratio (CAPE) which denotes the ratio of the current market price to the average inflation-adjusted profits of the ten preceding years. This CAPE measures whether the valuation of an equity market is high or low compared with its profit level - to which it will return in all likelihood.

    Barring a few exceptions, the CAPE quoted in a spread of between 10 and 24 on the American equity market from 1881-2013, regularly returning to its historical average of 16.5 (fig. 1). On only four occasions did it visibly breach upwards out of this spread: in 1901, 1928, 1966 and 1996. For each of these years plausible explanations were given as to why old valuation parameters should no longer be used, e.g. the introduction of mass production, the telephone, the departure from the gold standard, the computer age or globalization2. But investors were continually wrong: In each of these years the S&P 500 marked record highs. Investors who invested in these overvaluations regularly incurred real price losses over a period of 15-20 years.

    While high CAPEs signaled risks, attractive CAPEs and pessimistic market sentiment were followed by above-average capital growth over a long term horizon. In the S&P 500, the CAPE only fell below the value of 8 on three occasions: in 1917, 1932 and 1980. In each of these years, the S&P 500 marked historic lows - high returns of an average 10.5 percent p.a. were to follow in each of the following 15 year periods.
    International Evidence

    Even if no meaningful equity market forecasts are possible with CAPE in the short to medium term, realistic return expectations can still be derived for the following 10-15 years, and not only in the USA: We were able to confirm this connection in 14 other equity markets in the period 1979-2013.



    Connection CAPE vs. Real Returns of the 15 Following Years (p.a.)



    Table 1: All returns inflation-adjusted, in local currency, incl. dividend income and annualized. The „starting“ date is the year in which a CAPE was es-
    tablished for the first time. The last 15-year period taken into account encompasses the years 09/1998-09/2013, a total of 4,083 months were evaluated
    in 15 countries (#). The average CAPE corresponds to the arithmetical mean over the review period, e.g. from 1881-2013 in the US market. The min and
    max columns represent the minimum and maximum values observed in the relevant country, i.e. the 25%/75% quantiles of the real 15 year returns (med
    = median). Source: S&P 500: Robert J. Shiller, other countries: Woldscope, Thomson Reuters and own calculations.


    A connection between the CAPE and subsequent long-term equity market returns could be established in all reviewed countries (tab. 1). Attractive CAPE levels of below 8 were followed by high real capital growth of an annual average 13.1% over the next 15 years. In the most unfavorable case of all 4,083 observation periods, sequential annual returns of a real 5.7% were still established over the following 15 years, with the majority of sequential returns panning out at between 10.9% and 14.9%.

    By the same token, CAPE levels above 32 resulted in slight capital growth of an average 0.0%. The sequential returns mostly panned out at between -2.8% and 2.0%. While the US market was valued with an average CAPE of 16.5 based on data of Robert J. Shiller from 1881-2013, the average global CAPE of all 4,083 observation months is 17.5. All examination values without the US market, which accounts for 34.6% of all observation values, result in an average CAPE of 18.7. For the non-US data it is not possible to establish beyond doubt whether the different average valuation levels and the partially deviating interval sequential returns suggest country-specific fair valuation levels due to the short examination periods of 34 years, i.e. only two independent 15 year periods.
    However, given that a comparable connection can be seen across all markets, i.e. the average valuations - despite deviating examination periods, different markets and different accounting standards - deviate from each other by only 13%, the average CAPE is also higher in the US market from 1979-2013 than over the entire period (CAPE 21.2), and given that the CAPE only allows approximate forecasts to be made in any case, an internationally comparable connection must be assumed in the analysis below. Other arguments in support of this are the fact that even low correlated markets, such as Japan with CAPE levels of above 50, tally with this assumed connection and even complement the connection established in the US market (fig. 2).


    Connection CAPE vs. Real Returns of the 15 Following Years (p.a.)



    Figure 2: Connection between the CAPE and the returns of the 15 following years in the period 1881-2013 (US) and 1979-2013 (other markets). The USA,
    Japan and Germany are highlighted as examples in a single period 1979-2013. All returns inflation-adjusted, in local currency, incl. dividend income and
    annualized. Source: S&P 500: Robert J. Shiller, other countries: Worldscope, Thomson Reuters and own calculations.


    With a correlation of -0.7, a stronger statistical connection exists between the CAPE and the long-term sequential returns on the equity market than between the annual returns of the DAX and the S&P 500 in the period 1973-2013 (correlation 0.6). A further comparison: The company profits and the returns of the respective succeeding 15 years displayed a correlation in the US market from 1881-2013 that was only half as high (correlation 0.4). The CAPE thus allows more reliable long-term forecasts to be made than correctly…