by David Bassanese

The upward march of Wall Street has many analysts worried that the good times simply can’t last forever. They’re right – they can’t. But it is still far from clear the good times can’t last at least a few more years - before the next (inevitable) cyclical bear market - defined as at least a 20 per cent peak to trough decline in prices - takes hold.

Indeed, from a much broader long-run perspective, it is still less than clear whether the impressive Wall Street run since early 2009 is the first leg of a new secular bull market, or the second corrective rally in a much larger secular bear market that has gripped the Street since the dotcom crash more than a decade ago.  

One positive indicator is that prices in real terms have broken above the downtrend line formed from the last two peaks since early 2000.

That said, the latest note of caution has come from Nobel-prize winning US economist Robert Shiller, who recently observed that his measure of the S&P 500’s cyclical adjusted price-to-earnings ratio (derived from dividing current real share prices by the 10-year average of real reported earnings) is sitting at an above average 25.  Since the late 1800s, this measure has averaged a mere 16.6. 

Shiller noted that the CAPE had only been higher in 1929, 1999 and 2007 – and we all know what happened thereafter.

But does this mean the market is about to crash? Not necessarily. After all, the market can spend many years  at apparently above-average valuations before any correction sets in – crucial time that investors could miss decent returns if they’re always sitting on the sidelines.

Indeed, while the CAPE has spent only 123 months over the past 130 years – or 7.7 per cent of the time - above current levels of around 25.7, it has spent 47 per cent of the time above this level since the mid-1990s.  Either we’re enduring the biggest secular bull and bear markets Wall Street has even seen, or there’s arguably been a structural shift higher in the CAPE over the past few decades.

Of course, it’s always dangerous to argue this time is different. But there are a few factors that do still stand out.

For starters, US interest rates remain unusually low – and appear to have structurally shifted lower in the past few decades, thanks to lower inflation.  Compared to the last time yields were consistently this low – when also being held down artificially in the early 1940s – today’s CAPE valuation is higher.  But back then America was also happened to be in the middle of world war two.

Since early 2009, bond yields have fallen and the CAPE has increased – as might be expected during a cyclical recovery (se green line in chart above).  We might similarly expect the CAPE to decline again as interest rates normalise, but – looking at broad relationships over time - it’s quite conceivably the CAPE can hold at above long-run average levels of more than 15 if bond yields don’t rise beyond 4.5 per cent or so.

The other feature worth noting is the strong recovery in US corporate earnings since the financial crisis, which is consistent with a solid uptrend in real earnings since around the mid-1990s.  From a short-run cyclical perspective, real earnings are starting to look stretched, but there still appear scope for the solid underlying upward in real earnings to continue.  Indeed, the United States retains a relatively strong demographic outlook, and is fast becoming an energy super power thanks to its gas reserves.  It is also the world leader in the information technology revolution still sweeping the globe.

All up, America’s market valuations don’t appear that unusual considering the structural decline in interest rates in recent years and the strong uptrend in corporate earnings. Wall Street does not have the nosebleed valuations of the dotcom bubble, nor the cheap levels that double digit interest rates produced in the early 1980s.  It’s an environment in which moderate stock market gains are still possible if the economy continues to recover and the Federal Reserve withdraws policy stimulus carefully – as it has promised.  That said, the strong market gains – usually evident in the early stages of cyclical recovery – are likely behind us. 

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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