Michael Batnick, CFA, wrote this week on his The Irrelevant Investor blog about the ugly implications of today's 30x S&P 500^a cyclically adjusted price-to-earnings ratio (CAPE), should the irrepressible force, that is reversion to the mean, take hold:
And since we are 98 months into the current US economic expansion, the third longest stretch since 1854 (the two longer expansion periods were the 120 months from March 1991 to March 2001 and the 106 months from February 1961 to December 1969), it is only prudent to consider the downside risk of a recession-led CAPE reversion to the mean. Mr. Batnick does just that:
If the S&P 500 goes nowhere, and real earnings pick up to 2% a year (real earnings have been 1.25% for the last five years), the CAPE ratio will return to its long-term average in May 2030, 13 years from now.
If this sounds depressing, think about this, if stocks earn 0% for the next 13 years, returns have been so strong since 2010, that they still would have earned 4.02% (price only) over the previous 20 years. This is just slightly lower than the average twenty-year period of 4.54%. Even if earnings accelerated to 4% real, it would take a decade of zero returns for stocks to revert to their long-term average CAPE ratio.
Luckily we're able to get our stock exposure at more reasonable valuations overseas. Emerging markets trade on a 15.6x CAPE, developed Europe on a 17.8x CAPE, and the newest addition to AlphaGlider strategies, Singapore, trades on a 12.8x CAPE, per Norbert Keimling of StarCapital.
If real earnings were flat over the next three years, the S&P 500 would need to fall to 1725, a 30% decline, to fall back in line with its long-term average CAPE ratio.
Background reading: CAPE is a good predictor of long-term returns ⇒