Christine Benz talks to financial planning expert Michael Kitces. Kitches is a partner and the director of research for Pinnacle Advisory Group, and publisher of the financial planning industry blog Nerd's Eye View.
Investors often grapple with what specific factors might be predictive of future market performance. They might look at economic growth. One thing that some academic literature seems to support is that current market valuations are somewhat predictive of the returns that you're likely to expect. Your views?
There has been some interesting growth in the research out there of what really predicts long-term returns. And as you know, ironically--notwithstanding all the headlines about it--it turns out that things like GDP growth in the last quarter have almost no actual predictive value for markets over any useful time period. Certainly, in the aggregate over a multi-decade time period, how much the economy growth matters, but it has nothing in the way of actual predictive value.
Valuation is kind of an interesting one, though. What we're finding more and more from valuation is that it's actually still not very good at telling you what's going to happen with the markets in the next 6 or 12 months and where they are going in the near term. But it's perhaps better than we give it credit for in how much it actually predicts long-term market returns.
I suppose in some way the recent research on this really just goes back to Benjamin Graham almost a hundred years ago, who noted that, in the short term, markets act like a voting machine; in the long term, they act like a weighing machine. In the long term, valuation eventually comes to bear and either lifts up returns if things are cheap or drags down returns when they are more expensive.
When you look at various time periods over which valuation tends to be most or least predictive, you said in the short term it's not so predictive, while over longer time periods it is. But very long time periods, again, maybe not so effective.
It starts to break down. We've looked at lots of different valuation measures of this question of what works. Ironically, some of the ones that are most popular that we talk about most often really don't work very well.
Things like forward-looking P/E ratios tend to be very poor at predicting market returns over really much of any time horizon because, unfortunately, we just tend not to get forward earnings correct. Particularly in market returns, we usually don't see the recession coming until it is too late, and then we tend to overestimate the declines and underestimate the turns when they come. So, we find that forward P/E ratios don't work very well. Things like earnings over the past year are a little bit too short term.
The measures we find that work the best are those like the Shiller P/E ratio. It's often called cyclically adjusted P/E ratios, or CAPE, where we actually take 10 years' worth of trailing earnings, adjust them for inflation, and average them out over that whole time period. So, we get something that's kind of smoothed out for all the volatile market cycles, and that turns out to actually have some very powerful predictability of future market returns; but as you said, it's only over longer time periods.
When you look over a time horizon like a year, it turns out that Shiller CAPE is only slightly more predictive than monkeys throwing darts at stocks. It's almost random. It's ever so slightly better, but it's almost random. As the time horizon stretches out, though, it becomes much, much better, and there is actually an incredibly high correlation between Shiller market valuation and returns over the next eight years or so. It's actually quite good, and it explains almost half the variation in 8-year returns. So, it doesn't necessarily tell you how you're going to get there over eight years--it just says that from high valuation points, the market returns tend to be worse over eight years and then from low valuation points, they tend to be better.
When we inflation-adjust the data--looking at real returns instead--Shiller P/E ratios actually get even more predictive, but the time horizon gets longer. It's almost twice as long. So, we find out that Shiller P/E ratios are actually quite good at predicting things like 15-year real returns in equities--which ironically tells you very little about how to invest your portfolio right now. But it tells you a whole lot when you are trying to make decisions like how much can I safely spend from my portfolio, how much risk do I want to take overall in the next decade, and do I even have enough money to retire? Those sorts of questions are greatly impacted by market valuation.
Then, when we stretch the time period out even further, it actually starts to break down again. So, we've seen a lot of people say things like, "I'm just going to drag all my retirement spending way down because it looks like the 30-year return on the market has to be bad if valuations are so high." But we actually find that the predictability of valuation for 30-year returns is hardly any better than it is for one-year returns. So, one year is too short--markets happen because they are a voting machine; 30 years is actually too long because whole economies can restructure themselves over 30 years. We really find it's that eight to 15-year time period where it's really powerful, which matters a lot for, say, retirees thinking about sequence-of-return risk and accumulators who might be in their 40s or 50s and could be 10 or 15 years away from retirement and are trying to figure out whether the market is likely to cooperate with their portfolio growth and getting them to the finish line. But you have to be careful not to either focus too short or too long.
Right now, investors might be inclined to maybe tinker with their equity exposure, maybe to tilt toward parts of the equity market that look cheaper.
We can look at this in two dimensions. There is the absolute-valuation level--determining whether something looks expensive relative to historical standards and investment norms, which unfortunately suggests equities are at least a little bit high right now as an overall asset class. But absolutely, we can look within those and say maybe equities are high overall, but maybe I like large cap more than small cap because I'm concerned small cap is even worse, or maybe I like emerging markets a little bit more because I actually think they are a little bit cheaper than domestic markets. Obviously, those dynamics change over time as well.
So, it's certainly true that we don't have to look at this as just a single block--equities in one big bucket. We can and actually do drill down to a much deeper level as we go through our own investment process in looking at particular segments of the equity markets--particular sectors, capitalization sizes, domestic versus international--in trying to make those decisions about what's got at least a little bit more or less relative appeal, one versus the other, as well as just how much absolute appeal is there in equities versus fixed income or other alternatives.
This article initially appeared on Morningstar.com
