NASA unveiled an artist’s rendition of rare photos of an asteroid valued at $10,000 quadrillion.
The asteroid named “16 Psyche” measures an average diameter of about 140 miles (226 kilometers), according to NASA Science, and scientists have speculated that it is made up of mostly metallic iron and nickel, much like Earth’s core.
With the U.S. economy struggling to emerge from one of the worst recessions in history, it seems reasonable to ask why the S&P 500 is up 7% for the year. Are stocks wildly overvalued?
A measure that is often used to answer this question is CAPE – the ten-year average of the S&P 500 price/earnings ratio. According to it, stocks don’t seem to be overpriced at all.
In a recent paper published by the Federal Reserve Bank of San Francisco, economist Kevin Lansing notes that CAPE was at 30.9 at the end of the third quarter of 2020, or about 50% above its 60-year average of 20.5. A naïve conclusion from this observation would be that stocks are enormously overvalued. However, CAPE was higher two years ago, at 32.6 at the end of 3Q18. Yet, stocks climbed 20% since then and CAPE is now lower. How, then, can we use CAPE to know whether stocks are expensive or cheap?
Many pundits compare CAPE to its long-term average and, if it is significantly above it, conclude that stocks are overvalued. The obvious problem with this approach is that a long-term average is a value that only exists today: comparing stocks five years ago with a ratio that includes the then-unknown values of the following five years makes little sense. Yet, some insist on using CAPE this way. A slight improvement would be to use a moving average, for example.
Lansing from the San Francisco Fed uses a different approach. He notes that some economic indicators can account for fluctuations on the CAPE ratio, and he chooses three: interest rates, the growth potential of the economy, and uncertainty.
Interest rates, as we discussed in a previous post, are important determinants of the value of stocks (Warren Buffett said that they are “the most important” determinant) because lower rates increase the value of future dividends, and therefore of equities, even if earnings do not change.
The growth rate of potential economic output (a measure computed by the Congressional Budget Office) also influences the value of equities relative to earnings because if the economy has the potential of growing faster, so do future corporate earnings.
Economic uncertainty can be measured as the forecast error of various gauges of the economy, and is in fact tabulated in an index created by academics at Columbia and NYU. The idea is to measure the forecast error of various macroeconomic indicators. If it is true that “the market hates uncertainty” as we often hear, more uncertainty should bring down equity values because it puts future earnings in doubt.
Lansing runs a simple regression with these three indicators and comes up with a CAPE estimation that fits rather well with the observed values, especially in the last 20 or 30 years. A clear takeaway is that comparing CAPE to a fixed multi-decade average value not only does not make much sense but also