Thursday, April 16, 2015

P/E Multiples vs (Past and Future) Returns and Volatility

As I outlined in my previous post The Relationship Between Stocks and Bonds, the S&P 500 yields 3.7% at the current 27 CAPE (cyclically adjusted P/E), attractive from a relative basis to the sub 2% yield of the ten-year treasury. That said, a 3.7% yield is quite low by historical standards. Below is a framework for thinking about why returns should be expected to be lower AND more volatile than their long-term average given these low yields.  

Thinking about stocks in terms of CAPE duration

While bonds, without embedded options, have a pretty well-known duration, there is much less certainty regarding the duration of stocks. That said, a framework for thinking about stocks in terms of their sensitivity to changes in their yield is informative. Stock valuations are highly sensitive to their required yield, with materially higher "stock duration" in the form of P/E multiple expansion at a lower earnings yield than at a high earnings yield. 
  • Low yield = higher "stock duration": For example... at a CAPE of 40, the "required yield" is 2.5% (1 / 2.5% = 40). This means (ignoring convexity), valuations change 40% for each 1% change in the required yield.
  • Higher yield = lower "stock duration": On the other hand at a CAPE of 10, the "required yield" is 10% (1 / 10% = 10). This means (ignoring convexity), valuations change just 10% for each 1% change in the required yield.
Like bonds, the higher the duration (in the form of CAPE), means greater price sensitivity to a move in yield, which should be expected to result in higher forward volatility as well.

Historical returns drive the required yield and CAPE duration

The chart below looks at historical 5-year annualized performance of the stock market going back 50 years, bucketed into 10 distinct groups of ending CAPE values (<4% means the ending CAPE yield was less than 4%, which aligns itself to any ending periods with a CAPE above 25). 

As the chart highlights, low stock yields (and high CAPE) have historically been the result of strong stock performance, as investors are lulled into forecasting low volatility and high returns given their recent experience, despite the poor valuations a low yield means.

The historical result of a low CAPE yield / high CAPE duration

Given the framework outlined at the beginning of this post, one would expect:
  • Low yields = low returns
  • High CAPE duration = high volatility

So... it should come as no surprise that forward returns based on a starting CAPE yield were in fact lower and risk was higher. In fact, when CAPE yields have been less than 4%, the forward average return has been only slightly above 0% over the next five years with materially higher volatility. At the current 3.7% earnings yield, investors in the S&P 500 should not only anticipate lower than normal returns, but higher volatility. Another reason to be diversified to higher "yielding" stocks abroad.

Source: Shiller, S&P