Investing: Goldman Sachs destroys one of the most persistent myths about stocks

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A version of this post was originally published on TKer.co.

Let’s talk about the CAPE ratio. It’s one of the most widely-followed stock market valuation and investing metrics. It’s being talked about more as investors wonder whether stocks are poised to lose ground in 2022. Unfortunately, the signal of doom it supposedly sends is a myth.

CAPE, or cyclically adjusted price-earnings, was popularized by Nobel prize-winning economist Robert Shiller. It’s calculated by taking the price of the S&P 500 and dividing it by the average of 10 years’ worth of earnings. When CAPE is above its long-term average, the stock market is thought to be expensive.

Many market watchers use above-average CAPE readings as a signal that stocks should underperform or even fall as it reverts back to its long-term mean.

But CAPE’s mean doesn’t actually have much pull.

Bull and bear, symbols for successful and bad investing are seen in front of the German stock exchange (Deutsche Boerse) in Frankfurt, Germany, March 25, 2020. REUTERS/Ralph Orlowski

“While valuations feature importantly in our toolbox to estimate forward equity returns, we should dispel an oft-repeated myth that equity valuations are mean-reverting,” Goldman Sachs analysts wrote in a new note to clients.

The analysts began their discussion by noting that the problematic assumption that a mean exists for metrics like CAPE to revert to.

“Mean reversion assumes that market valuation metrics … are stationary and their long-term means do not change,” they wrote.

In recent decades, valuation metrics have been persistently high, which have actually forced these long-term means to move higher. Not long ago, GMO’s Jeremy Grantham made this observation to argue that valuations were in a “new normal” at elevated levels.

Jeremy Grantham, Co-founder and Chief Investment Strategist of GMO, takes notes during an Oxford-style debate on financial innovation hosted by “The Economist” magazine at Pace University in New York October 16, 2009. REUTERS/Nicholas Roberts

‘We have not found any statistical evidence of mean reversion’

At any rate, the case for mean-reversion is weak.

“We have not found any statistical evidence of mean reversion,” the Goldman Sachs analysts wrote. “Equity valuations are a bounded time series: there is some upper bound since valuations cannot reach infinity, and there is a lower bound since valuations cannot go below zero. However, having upper and lower bounds does not imply valuations are stationary and revert to the same long-term mean.”

The Goldman analysts did the math, and the key metric to look at in the chart below is the statistical significance.

“The statistical significance over the full sample is 26%. This means that there is only 26% confidence that the Shiller CAPE is mean-reverting, and 74% confidence that it is not. The traditional threshold to consider a relationship statistically significant is 95%.”

(Chart: Goldman Sachs)

In other words, you can’t rely on CAPE to gravitate toward any mean.

The Goldman analysts, however, weren’t done busting the myth and took issue with the concept of the CAPE ratio in general.

“Even if we ignored this threshold, the time between valuations crossing into their 10th decile and reverting to their long-term average is beyond a reasonable investment horizon for a tactical decision,” they said. “For example, the Shiller CAPE entered its 10th decile in August 1989 but did not revert to its long-term mean for 13 years.“

In other words, trading based on the assumption CAPE will mean-revert could lead to indeterminate years of getting smoked by the market.

It’s worth repeating

There’s not much new here. The Goldman analysts have addressed this myth in reports published in 2013, 2014, 2018, and 2019.

They note that this isn’t just a CAPE-specific issue but an issue with many valuation metrics, including valuation metrics applied to non-US stock markets.

I’ve flagged this problem recently here and here. I’ve written about it at Yahoo Finance here and at Business Insider here and here.

Prominent folks have been sounding off on CAPE issues for years, including veteran Wall Street strategist Sean Darby, finance professor Jeremy Siegel, legendary investors Warren Buffett, and blogger extraordinaire Michael Batnick.

Even Shiller himself has warned about CAPE’s reliability.

Still, a simple Google search for “CAPE ratio” will return years of articles about how the market is about to crash. As you can see, it’s being talked about now as stocks have had a bumpy ride to start the year.

Robert Shiller, one of three American scientists who won the 2013 economics Nobel prize, attends a press conference in New Haven, Connecticut October 14, 2013. REUTERS/Michelle McLoughlin

The big picture

“We want to emphasize that valuations alone are not sufficient measures for underweighting equities,” the Goldman analysts wrote. “High valuations do not reach some magical target and then revert to some stable mean; furthermore, the time period for valuations to reach some long-term average is highly variable and therefore uncertain.”

Valuation metrics like CAPE and forward P/E aren’t totally worthless. By definition, they offer a simple way of estimating the premium an investor pays for a company’s earnings.

However, they simply don’t do a great job of telling you what stock prices will do in the coming days, months, or even years.

A version of this post was originally published on TKer.co.

Sam Ro is the author of TKer.co. Follow him on Twitter at @SamRo.

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