Current Views on the Market

By Ben Ferris, CFA

“If you spend more than 13 minutes analyzing economic and market forecasts, you’ve wasted 10 minutes.” – Peter Lynch 

I believe it is fruitless to spend much time worrying or forecasting macroeconomic factors. Gaining an informational edge in this arena would be essentially impossible even if there were only a handful of daily datapoints to analyze, let alone thousands. However, I think it is important to have a bird’s-eye view of where the markets are in the economic cycle. I think it is especially helpful when markets hit extreme valuation levels. Hopefully this only takes three minutes to analyze and review. If it takes you longer, I owe you some minutes back and please let me know your hourly rate – I’ll make sure Jack reimburses you with a personal check! 

One high-level valuation metric that I always like to keep an eye on is the Shiller CAPE P/E 10 ratio (where CAPE stands for cyclically-adjusted price to earnings), named after the Nobel Prize-winning economist Robert Shiller. 

This ratio is calculated by taking the price level of the S&P 500 (about 3,100 at the time of this writing) and dividing it by the average earnings of the companies in the index over the last ten years, adjusted for inflation. The idea is to value companies based on their earnings power over the course of an economic cycle, which typically lasts about ten years. The higher the ratio, the more expensive the market is. As you can see in the chart below, we are currently at a very high level (30), almost double the long- term average. 

While there are some flaws with this metric, it has proven to be extremely useful at predicting long-term returns for stocks. In fact, since 1970, there has been a 0.75 correlation between the ratio and the future 10-year gain on the S&P 500, with high CAPE ratios correlating to low 10-year returns. It is informative to see how US equities have performed in subsequent periods when the CAPE ratio is at high and low levels. The chart below shows the three lowest and highest CAPE ratios going back to 1881 and the subsequent one, three, five, and ten year returns for the S&P 500. 

This valuation metric has not been a good predictor of one or five-year returns, and there is nothing to say that it will continue to be a good predictor of ten-year returns going forward. However, I do believe there are some important takeaways. 

In the short-run, it is anyone’s guess where the market will go, but when thinking about long-run potential returns, starting-point valuations matter. With the current Shiller 10 ratio currently at 30.5, we are much closer to historical highs than to the lows, and the Shiller regression would predict a negative 2% compound annual return on the S&P over the next ten years. This model could certainly prove to be way off the mark, but it does serve as a helpful guidepost. 

Another bird’s-eye view indicator that Warren Buffett often references is the ratio of the market value of all US stocks to US GDP. The higher the ratio, the more expensive stocks are relative to underlying economic activity. We are near all-time highs on this ratio.

All of this can be summarized by saying the market as a whole is expensive. Fortunately, we do not “buy the market” at Trust Company of Vermont. We select investments in high-quality businesses we understand, that have durable competitive advantages that can outperform regardless of the macroeconomic environment. 

We cherish the privilege our clients bestow on us to select individual stocks. This allows us to make purchases based on the merits of the business and the price at which we can pay to become an owner. We believe this process allows us to reduce risk and increase potential returns for our clients. 

As always, should you have any questions about your portfolio, please do not hesitate to contact your Investment Manager.