As we have covered in depth throughout the year, the U.S. stock market has become increasingly overvalued when looking at long-term measures of valuation. The CAPE ratio, one such metric, is in the ninth decile of historical valuation meaning that US stocks have been cheaper 90% of the time than they are today using this measure. While it is a notoriously poor indicator of how markets are likely to perform over the short-term, if history is any guide, the CAPE ratio is very reliable in predicting that returns from this point will be poorer than average over the next market cycle. More notably, at these CAPE levels, some episodes of extremely negative outcomes have ensued in the following years.
The CAPE is now at a level only seen on three other occasions over the last 130 years: 1929, 2000 and 2007. Robert Shiller tried to explain the reasons behind the valuations in a recent New York Times article, “The Mystery of Lofty Stock Market Elevations;” however, he wrote, “So nothing I’ve come up with is a slam-dunk explanation for the continuing high level of valuations. I suspect that the real answers lie largely in the realm of sociology and social psychology — in phenomena like irrational exuberance, which, eventually, has always faded before.”
At a minimum these valuation levels are likely to constrain future returns from U.S. stocks, but there are opportunities that are attractively valued from today’s starting point. One of those areas is in emerging markets. Emerging markets are cheap relative to domestic equities and have attractive future earnings growth potential. Since early summer we have been reducing our allocation to domestic equities and increasing our allocation to emerging markets within Market Risk.
While indeed the valuations are attractive from today’s starting point, there is the possibility for more volatility, as the Wall Street Journal discusses in the article “Is it a Good Time to Invest in Emerging Markets.”
For this reason and also due to the regional and country complexities within the emerging world (for example China, which continues to be a big “unknown”), our Investment Strategy Team was very selective in vehicles in which to invest. Active management allows the flexibility to navigate the risks and capture opportunities as opposed to an index.
As always, our Investment Strategy Team looks for creative ways to add value to portfolios without adding undue risk. Therefore, we are watching a number of indicators for potential exit points from the position. These indicators focus on the relative performance of emerging markets versus domestic markets and include price momentum, fundamental factors, cash flow yield and profit margins.
Please let any Investment Strategy Team member know if you have any questions.
 The CAPE ratio is the cyclically adjusted price-to -earnings ratio, where the earnings base is the moving average over the last 10 years adjusted for inflation.