August 30, 2018

How Elm Works

The Most Important Number Not Printed in the WSJ

By Victor Haghani and James White 1

We are often asked for our estimate of the long-term return of the equity market. Our framework currently indicates 5.3% above inflation for global equities, which we know strikes many investors as high. This is understandable, given that the most available and frequently cited valuation ratio – the S&P500’s CAPE2 – currently stands at about 30, which is higher than it’s been 96% of the time since 1900 and far above its average level of about 17.3

How do we arrive at our estimate of 5.3% real return? First, we need a simple and fundamentally sound predictor for each major regional equity market. One such measure is the Cyclically Adjusted Earnings Yield, i.e. 1 / CAPE, as suggested 30 years ago in a seminal paper by Shiller and Campbell.4 While there isn’t enough historical data to statistically derive a high level of confidence in this predictor, such evidence as there is combined with its fundamental economic rationale supports its use as a reasonable indicator.5 By way of anecdotal context, the Cyclically Adjusted Earnings Yield in 1968 was 4.6% for US equities, and the actual real return over that period has been 5.8% – not spot on, but not too bad either given all that’s happened over those 50 years.6

Next, we need a good decomposition of the global equity market. The table below presents current data:

Region CAPE Earnings Yield (1/CAPE) Market Cap. Weights
US 28.4 3.5% 37%
x-US Developed 18.5 5.4% 31%
Emerging Markets 13.9 7.2% 32%
Global Earnings Yield 5.3%
Source: World Federation of Exchanges, Bloomberg, MSCI.7

As you can see, non-US equities offer a much higher earnings yield than US equities. This has a major impact on our return estimate given non-US equities represent almost 2/3rds of the global equity market on the basis of pure market capitalization. There is good evidence that investors, and particularly US investors, tend to significantly over-weigh the US in their thinking about global equities. Even though the US represents less than 25% of global GDP and less than 5% of global population, many investors think of the US equity market as a proxy for the global market, which just isn’t the case. The big index providers, MSCI and FTSE, are also partly to blame for this biased perception, as they assign a weight of over 50% to US equities as a result of adjustments they make for free-float and investability factors. They do this so that their indexes can be investable on a massive scale with minimal distortions, but at the cost of rendering their indexes less representative of the global market. Fortunately, investors who are not constrained to track MSCI or FTSE indexes can achieve a truer and more balanced representation of the global equity market, particularly on a forward-looking basis, by using un-adjusted market cap weights as presented in our table – so long as not everyone tries doing this at the same time.8

Another reason that our estimate may strike some investors as high is that we do not make an adjustment for the reversion of CAPE to its historical mean level. In a recent Bloomberg note, we explained why deviations from the mean for CAPE don’t actually tell us much about expected market returns above and beyond what the absolute level of CAPE already tells us. Hence, including mean-reversion does not improve CAPE as an indicator of long-term return.9

We don’t include market momentum in our estimate, as we are focused on long-term returns and the effects of momentum average out to zero over long time horizons. We also stopped short of making an adjustment for taxes, as this will vary according to personal circumstances.10 As a general matter, equity investing is among the most tax-efficient forms of long-term investing, given the ability to defer capital gains and the preferential treatment of dividends in many tax regimes.

The simple framework we’ve described in this note is not meant to have near-term predictive power. Instead, we hope it provides a useful starting point for thinking about the long-term return of equities, which is one of the most critical inputs into lifetime decisions about how to invest, save, and spend.

  1. Victor is the Founder and CIO of Elm Partners, and James is Elm’s CEO. Past returns are not indicative of future performance. This not is not an offer or solicitation to invest.
  2. Cyclically Adjusted Price to Earnings ratio, which is the current equity index price divided by the past 10 years of inflation adjusted earnings. CAPE was first suggested by Graham and Dodd (1934), but popularized by Professor Robert Shiller.
  3. Using Robert Shiller’s reference data.
  4. Campbell and Shiller, “Stock Prices, Earnings and Expected Dividends”.
  5. We have presented our views on this several times in the past, such as in this Elm video from three years ago: The Most Important Number You Won’t Find in the Wall Street Journal (2015).There is a plethora of literature on this subject, presenting sometimes opposing perspectives, and we recognize that it is more the topic of a book than a one page note. A variety of simple structural corporate-growth models can produce the result that real equity returns will be centered around the earnings yield.
    One basic condition under which real returns will equal the earnings yield would be if company earnings can grow with inflation with all earnings paid out currently to shareholders. While these models are all caricatures of the real world in a variety of ways, they nonetheless provide a solid starting point for making sense of long-term historical data. For a more up-to-date evaluation of CAPE as a predictor of real equity returns, particularly assessed in non-US equity markets, see Keimling and Huber (2016). They conclude:
    “Existing research indicates that the cyclically adjusted Shiller CAPE has predicted long-term returns in the S&P 500 since 1881 fairly reliably for periods of more than 10 years. Furthermore, the results of this paper indicate that this was also the case for 16 other international equity markets in the period from 1979 to 2015.”
  6. Again Robert Shiller’s reference data.
  7. CAPE figures are based on an average of MSCI and Bloomberg historical earnings numbers for major regional markets. For non-US markets, historical earnings are converted to US dollars at historical exchange rates and the current index price is converted to US dollars at the current exchange rate.
  8. See our note here for a fuller discussion of how we arrive at our regional equity market weights in our Baseline portfolio, which are in between the unadjusted market cap weights from the table and the MSCI and FTSE adjusted weights.
  9. The main points in our note were that much of the apparent mean-reversion in CAPE is explained by cyclically adjusted earnings catching up with stock prices, rather than the other way around, and the fact that a random walk will give the illusion of mean reversion when looking backwards, but in reality we won’t know the mean of the distribution in advance.
  10. For the sake of clarity, in this note we’ve put to the side a further consideration in thinking about equity returns, which is the “convexity” effect, stemming from equities having the attractive characteristic of unbounded upside and bounded downside.
    Our return estimate is a central estimate of the long-term return, but if the actual long-term compound return turns out to be 2% better than the estimate, that results in a much larger gain than the loss for a return 2% lower than our estimate. This convexity effect can have a material impact on asset allocation decisions, depending on the magnitude of return variability. See our paper on this topic here.