The century-long valuation lesson of US stocks: Don't expect too much in the future!

The accounting rules of "mark-to-myth" continue to exaggerate earnings.Another recent distortion phenomenon is the extensive use of off-balance-sheet tools to conceal corporate debts and leverage levels, and to boost income. In a scenario of relatively weak income growth, income can be boosted through massive cost cutting, increased productivity, labor outsourcing, and other means. The trend of companies buying back shares has reduced the number of outstanding shares, thereby increasing earnings per share and supporting higher asset prices. This point has played an important role in driving up valuations over the past 15 years. As mentioned earlier, despite sluggish income growth, stock buybacks have fueled the growth of earnings per share. Impact of buybacks on profitability Since 2009, reported earnings per share have grown by 676%, making it the fastest period of earnings per share growth following an economic recession in history. However, this significant growth is not attributed to operating revenue (i.e. sales revenue). In fact, during the same period, sales revenue only grew by 129%. As mentioned earlier, 75% of the profit growth comes from stock buybacks, accounting methods, and cost cutting. Reported earnings vs. buybacks Using stock buybacks to boost earnings per share can distort long-term valuation metrics. As mentioned in a 2012 article by The Wall Street Journal: "According to an academic study, one-fifth (20%) of American finance chiefs have been constantly trying to adjust their company's profit figures." It is not surprising that this is a "public secret". Companies use "cookie-jar" reserves, adopt accruals and other accounting tools in large quantities to beautify or deflate profit figures. Even more surprising is that CFOs believe that these practices have a significant impact on the reported profits and losses of the company. When asked about the extent of profit distortion, respondents estimated it to be around 10% of earnings per share. Cooking the Books Unsurprisingly, 93% of respondents pointed out that "stock price pressure" and "external pressure" were the reasons for manipulating profit figures. This "manipulation" further suppresses valuations by exaggerating the "E" in the CAPE ratio. Another issue is duration mismatch. Duration Mismatch Imagine this: when you construct an investment portfolio containing fixed income, one of the biggest risks is "duration mismatch." For example, suppose you buy a 20-year bond but need the money in 10 years. Since the main purpose of holding bonds is capital preservation and income generation, this duration mismatch becomes crucial. If interest rates rise during those 10 years, you will incur capital losses when selling the bond. Similarly, it is reasonable to assume that a "duration mismatch" exists between Schiller's 10-year CAPE and the current financial markets, with the rapidly changing financial market environment, shortened business cycles, and increased liquidity. The chart below shows the annual price-earnings ratio (P/E ratio) compared to the inflation-adjusted S&P 500 index. Historical valuations vs S&P 500 index Importantly, you will notice that during long bear markets (shaded areas), the overall trend of the P/E ratio is downward. This "valuation compression" is part of the entire business cycle, as over time, the levels of "overvaluation" gradually revert to the mean. You will also find that during these periods, market prices typically exhibit "sideways movement" and increased volatility. Furthermore, since the early 21st century, valuation fluctuations have significantly increased, which is one of the main arguments against Schiller's 10-year CAPE. However, is there a better measure? Introducing CAPE-5 ratio To better understand the fundamental trends in valuations, smoothing out earnings fluctuations is necessary. For investors, the major returns in financial markets over the past 125 years have come from periods of "valuation expansion." In contrast, during periods of "valuation compression," the returns are lower and more volatile. Therefore, to adapt to potential "duration mismatch" in a faster-changing market environment, I have recalculated the CAPE ratio using a 5-year average as shown below. CAPE-5 valuation vs S&P 500 index The movement of CAPE-5 is highly correlated with the S&P 500 index. However, you will notice that before 1950, changes in valuations were more in sync with the overall index because price movements were the main driver of valuations. After 1950, as earnings growth accelerated, the impact of price movements gradually diminished, and the CAPE-5 ratio began to lead overall price changes. Since 1950, the decline in the CAPE-5 ratio has been an important warning signal for investors, indicating an overall market price decline. The recent decline in the CAPE-5 ratio is directly related to rising inflation and monetary policy tightening due to higher interest rates. However, when the CAPE-5 ratio begins to revert to the mean, the optimistic belief that "this time is different" may prove to be wrong. Significance of deviation By observing the deviation of current valuation levels from the long-term average, one can better understand the current valuation position relative to history. Understanding the importance of deviation is crucial, as valuations historically must be sometimes above and sometimes below an "average." These "averages" exert a gravitational effect on valuations over time, so the greater the deviation, the more significant the eventual "mean reversion." The chart below shows the percentage deviation of the CAPE-5 ratio since 1900 relative to its long-term average. CAPE-5 vs S&P 500 index (1900-present) Currently, the CAPE-5 ratio at 15.86 times earnings is 107.01% above its long-term average of 7.66 times earnings, indicating that the current valuation level has only occurred twice in history. As mentioned earlier, although people hope that "this time is different," this common expectation was shared in the previous five similar instances, but the eventual results are often not optimistic. However, it is worth noting that the post-World War II economic prosperity, changes in operational capabilities, and productivity necessitate a separate examination of the period from 1944 to the present. CAPE-5 vs S&P 500 index (1944-present) Similarly, in comparison to the long-term perspective mentioned above, the current decline in the CAPE-5 ratio is highly correlated with the rise in inflation and the monetary policy tightening caused by higher interest rates. However, when the CAPE-5 ratio starts to revert to the mean, the belief that "this time is different" may be proven wrong.The average return after World War II was 17.27 times higher, exceeding 90.15%. In the past 80 years, this level of deviation has only occurred twice, in 1996 and 2021. The subsequent "return" is not friendly to investors with a long-term perspective.Conclusion Is the CAPE-5 ratio better than Shiller's CAPE-10 ratio? It is possible, as it can more quickly reflect rapidly changing market conditions. However, it should be emphasized that whether Shiller's CAPE-10 ratio or the improved CAPE-5 ratio, neither should be used as a tool for "market timing". Valuations determine future returns, and their main role is to identify periods with very high investment risks that may lead to poor future returns. Current valuation indicators clearly indicate that future market returns will be significantly lower than the levels of the past 15 years. Therefore, if you expect the market to provide a 12% return per year in the next 10 years to achieve your retirement goals, you are likely to be disappointed. This article is reprinted from the "Ying Wealth" public account, edited by GMTEight: Li Fo.