Episode #184: You Could Have Missed…
Guest: Episode #184 has no guest, It’s a Meb Short.
Date Recorded: 2/27/19
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Summary: Episode 184 is a Meb Short. In this episode, you’ll hear Meb discuss the CAPE ratio, flawed logic behind the conclusion that “CAPE doesn’t work,” probabilistic investing, and a global perspective on CAPE.
All this and more in episode 184.
Links from the Episode:
- :50 – Welcome
- 1:26 – You Would Have Missed 961% In Gains Using The CAPE Ratio, And That’s A Good Thing (Faber)
- 3:02 – Don’t Be a Yield Pig (Klarman)
- 6:30 – Musings on Markets
- 6:43 – Flawed logic behind “CAPE doesn’t work”
- 7:09 – The Meb Faber Show – Episode #39: “If You Bet Too Much, You’ll Almost Certainly Be Ruined”
- 9:04 – STAR Capital and Who Ate Joe’s Retirement Money? (GMO)
- 11:17 – Can CAPE tell you when to switch asset classes
- 14:11 – Where does Meb differ on CAPE from others
- 15:00 – CAPE Distribution
- 16:30 – Wrap up
- 17:27 – Pinned Tweet 5 Global Stock Valuation Resources
Transcript of Episode 184:
Welcome Message: Welcome to “The Meb Faber Show,” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb: Welcome, podcast friends, it’s time for another mebisode, which means you get to hear my sweet, lovely voice, hopefully at 2x speed. You guys might even be able to do two-and-a-half or 3x speed at this point with me. I talk so slow in a monotone. By the way, Overcast even has a feature called Smart Speed that lets you reduce the time. Although I think my favourite apps right now are Breaker and RadioPublic. I go back and forth. Anyway, today we have a fun one. You guys have probably heard me talk about this before. So, if you feel like you’ve heard me talk enough about valuations, you could probably skip it. But for those of you that haven’t, this is an update to a post that we published back in 2016. And it’s one of the most often heard criticisms of one of our favourite metrics, the CAPE Ratio. And a lot of people repeat it over and over and over again.
So, I think this is a fun framework, with which to think about how to use valuation. A lot of people say you can’t use the CAPE Ratio for market timing or for anything really, but this is a different way to think about it that I think is a lot of fun. So, buckle in, today’s topic, title of the podcast, you would have missed 961% in gains when using the CAPE Ratio. And that’s a good thing. Let’s get started. Nine hundred and sixty-one percent, that’s the amount of gains you would have forgone had you followed the market timing strategy I’m going to describe in the following podcast that utilises the CAPE Ratio. Yeah, that’s significant. But there’s far more to the story. I suspect that had you acted on this strategy, you would have actually been quite happy to miss out on those gains. Let’s start by rewinding a few decades.
The year was 1993. Over the prior decade, stocks had quintupled in value, returning about 17% per year. Man, that’s awesome. You get to be pretty rich pretty quick at 17% per year. A thoughtful investor may have taken pause after this massive run. Indeed some did, including renowned investor, one of my favourites, Baupost’s Seth Klarman, one of the best hedge fund managers of all time. Following, I’m gonna read a short excerpt from an article Klarman contributed to Forbes in 1992 titled, “Don’t Be A Yield Pig.” By the way, if you guys didn’t see our Forbes profile, I can’t really send it out because it mentions some of our funds. Check it out as the end of the year, you get to see some pretty embarrassing photos of me standing in a sea of Ivy and talking on the podcast. Look it up. Anyway, “Don’t be A Yield Pig,” is the name of his article.
And this is Klarman’s quote. “Some investors, desperate for better yield, have been reaching out, not for a new Wall Street product but for a very old one. Common stocks, finding the yield on cash unacceptably low. People who’ve been investing conservatively for years are beginning to throw money into stocks, despite the obvious high valuation in the market that’s historically low dividend yield and the serious economic downturn currently underway. How many times have we heard in recent months, that stocks have always outperformed bonds in the long run? Funny, but we never hear that argument at market bottoms. In my view, it’s only a matter of time before today’s yield pigs are led to the slaughterhouse.
The shares of good companies and bad companies alike are vulnerable to sharp declines. Moreover, many junk bonds that have rallied, will tumble again and a number of today’s investment-grade issues will be downgraded to junk status if the economy doesn’t begin to recover soon. What if you depend on a higher return on your money and can’t live on the income from 4% interest rates? In that case, I would advise people to ignore conventional wisdom and consume some principle for a while. And if necessary, rather than reach for yield and incur the risk of major capital loss, stick to short term U.S. government securities, federally insured bank CDs or money market funds that hold only U.S. government securities. Better to end the year with some 98% of your principal and tax than to risk your capital roofing around for incremental yield that is simply not attainable. I would also counsel conservative income-oriented investors to get out of most stocks and bonds now, while the getting is good. Caution has not been a profitable investment tax for a long time now. I strongly believe it is about to make a comeback.”
Klarman’s words were certainly strongly cautionary. So what was exactly the state of the market at the time in which he wrote them? Just how expensive was it? The long-term cyclically adjusted price-earnings ratio, the CAPE Ratio, Shiller’s, my favourite, had just crossed above 20 at the end of 1992. This placed it on the high side of historical valuations of around 16, though not by too much. And investors had seen similar valuations in the ’60s, ’20s, 1900s. A bullish-oriented investor could have easily brushed aside overvaluations warnings as a CAPE of 20 put the market nowhere near bubble territory, not the max rating of 33 that CAPE Ratio reached at the peak of the roaring ’20s.
Remember, this is 1993, so at the time. Nevertheless, let’s say a conservative investor heeded Klarman’s warning and the elevated CAPE and sold all of his stocks. Now, what this investor couldn’t have known at the time is that the CAPE Ratio would remain elevated for most of the ensuing 20 years, with the brief exception of CAPE Ratio getting cheap in 2008, 2009. So, what sort of miss market gains would have translated into for this individual? As referenced at the top of this paper, 961%. That’s a lot.
Indeed, from ’93 to 2018, stocks have averaged about 9% per year. This would lead many investors, and believe me, it has led to many commentators and emails, to conclude that using valuation metric like CAPE was a poor choice, a broken, useless indicator, or as Professor Damodaran concluded, “This is one of the most oversold, overhyped metrics I’ve ever seen.” And that’s coming from the Dean of Valuation at NYU. I love the professor and his work, by the way. He’s got one of the old school blog spots. There’s only about five of these. It seems like less old school blogspot themes from, like, 1998. I hope he never changes. But with all due respect, I think the professor…a lot of the haters would be wrong. So, here’s the flawed logic behind CAPE doesn’t work. Imagine you’re in Las Vegas. I love Vegas. By the way, it has great rock climbing west of town. I just saw Free Solo, which I think at this point is probably the greatest human physical achievement I’ve ever seen, just astonishing. Great documentary, check it out. But let’s say you’re not in Vegas for the rock climbing, or mountain biking, or wake surfing, but you’re there to play blackjack. Go listen to our old episode with that Ed Thorp if you wanna learn how to beat the dealer, count cards.
A tourist sitting at the end of the table in a Hawaiian shirt is showing a great hand, a king nine for a total of 19. The dealer’s face-up card is a six. The tourist has had a few too many drinks at the table, motions for the dealer, another card. You, being of sound mind, sober mind, and statistical knowledge know this is a near-guaranteed suicide move. The drunk tourist is transforming a hand with a high odds of winning into a near-guaranteed bust. Before the dealer can turn over the card, you blurt out, “Are you sure about that? “The tourist ignores you, scoffs, and receives the extra card. Turn out the gambling gods are on his side and he draws a 2. Twenty-one, the dealer draws to a 19. You lose and the tourist wins his bet. He turns in your direction, sneers and says, “I told you it was the right move,” collects his winnings, moves onto the slots, where he’ll not be bothered by the snooty likes of you.
The tourist won the hand. But does that mean he made a good bet? Of course not. He transformed his odds of winning the hand from roughly 70% to an almost certainty of losing by taking another card. This dynamic is no different in the investment markets. If markets are overvalued, is it a safer bet that markets will continue rising or offer subpar returns? Statistically, the likely outcome is subpar returns. Of course, that doesn’t mean that markets won’t continue climbing despite lofty valuations. And, of course, a bullish investor could make such a bet as did the tourist and win. As we’ve demonstrated in the past, a cheap up-trending market is the best but guess what second-best is? An expensive up-trending market. But that doesn’t mean it’s necessarily a good wager. Most investment research has shown that when people buy an expensive market, they have a higher chance of big fat drawdowns in their future.
We’ll post a few charts that we’ll add to this podcast link from GMO, Star Capital, we’ve done it as well, to demonstrate this phenomenon, that the more you pay for a market on valuation, doesn’t even matter what valuation metric you use, the higher chance you have a big fat loss in the ensuing three to five years. So, critics may reply, “Okay. But I’m rational and I can sit through drawdowns, the mantra of the buy and hold investor. What else you got?” Well, the data has shown that we would have missed out on 961% in gains. Ipso facto, CAPE doesn’t work. Not quite. First, even though you claim you can sit through drawdowns, nearly all the research on investor psychology suggest most can’t. But that’s a different discussion. For the moment, let’s just assume you decided to get out of stocks. If so, what would you have done with your money? After all, getting out of stocks would have meant getting into some other asset class. Unless you were like my granddad, who literally kept his money under the mattress, you have to do something with that cash.
You could have parked your money in government bonds, how would that have done? So, if we look at returns from 1993 to 2018, U.S. stocks did about 9% per year, government bonds did about 6%. Thirty-year government bonds did about 8%. So, not quite stock-like returns. Long-term bonds had solid but similar volatility of stocks. More importantly, though, 30-year bonds had about half the drawdown suffered by stocks. So, stocks lost half and long-term bonds only lost about a quarter. So, it’s a smoother ride. So, it may have increased the odds if you stayed…invested and actually saw this return. All three of these choices had a similar Sharpe ratio of around 0.4. U.S. stocks had the highest 0.47. Thirty-year bonds, lowest at 0.39 but pretty darn close, which is risk-adjusted returns.
We’d expect this over long periods, of course, is most asset class cluster around Sharpe ratio is around 0.2 or 0.3 over time. So, 0.47 of stocks over the past quarter-century is quite a bit higher than the historical 0.3 over the past full century. So, 961% in S&P but had you invested in 10-year bonds, you’d still done 400%, and 30-year bonds, almost 700%. It’s a pretty darn close and a smoother ride, a smoother Sharpe ratio. But, again, stocks won. Let’s look at a different idea. Can CAPE tell us when to switch asset classes? So, if we needed the CAPE Ratio to be a bit more agile for us, rather than just telling us when to move out of stocks and bonds and be done with it, what if we need it to tell us when to be in stocks versus when to switch to bonds, possibly switch back? How would all this perform?
I made an arbitrary rule, switching system. We’re in stocks when the CAPE is less than 20, which is what it crossed in ’93. Otherwise, in bonds when it’s above 20. So, we valuate the switching system with both 10 and 30-year bonds. How did the numbers shake out? Well, the basic switching system would have done a good job alerting you when to make the leap from stock to bonds. In both cases, risk-adjusted return has climbed. But what happens when we use 30-year bonds? All the metrics improve, returns, volatility, Sharpe drawdowns. So, if you look at the switch system, it took the 10-year returns from 5.6 to over 7, increase the drawdown a little bit. But for the 30-year, it took 7.5 up to 9.28. Technically higher than the stocks return of 9.1. And it had half the drawdown and no higher Sharpe ratio. And by the way, picking 20 is an arbitrary starting point. That wasn’t any sort of thoughtful data mining. We just picked it because that’s where it started in ’93. So, even at this point, it appears we have strong evidence that using CAPE is, in fact, an effective timing metric.
But if you’re not convinced, we can sway you with another tweak. The world, your friend, is my oyster. A moment ago, we made the point selling stocks means starting a new position in some other asset class. Our earlier example investing in U.S. bonds is that other asset, but we don’t live in a world consisting of just two assets, U.S. stocks and bonds. Savvy investors will always seek out assets or a position to offer the best return on investment regardless of the location. So, why not replace U.S. bonds with the cheapest stock markets in the world? Another word for that, let’s use a value approach, something like Warren Buffett or Ben Graham might have used. In this scenario, let’s compare our switching system to a new strategy in which we invest in the cheapest global stock markets, again, as identified by the CAPE Ratio. This strategy beat the S&P 500 by four percentage points per year, despite a little higher volatility, which is by the way, mostly the good upside volatility, it still resulted in higher Sharpe ratio and lower drawdowns than sitting in expensive U.S. stocks.
So, stocks did 9.1%, investing in the cheapest stocks being country agnostic, did 14% over that period, again, higher volatility but also higher Sharpe, and a lower drawdown. So, let’s return to our conservative investor, wondering what to do with his money at the end of 1992. By forgoing an expensive market, by CAPE standards, he missed 961% in U.S. stock gains. But how to use a value approach? CAPE applied to the global investment set, he would have realized 3,051% gains, instead. So, does CAPE appear broken to you? So, where do we differ? Perhaps the source of this whole CAPE works, CAPE doesn’t work argument reduces to a simple misunderstanding. It seems detractors are asking CAPE to clearly tell us in or out applied to just one asset class or market. But is that fair? Is that even rational? No. We do argue that investing is all about finding value anywhere and not just in a binary decision, is this market expensive or not? But rather, where can I find the best returns anywhere?
No single metric is ever able to tell you with 100% actually when to buy and when to sell out. That’s demanding perfect future knowledge, which is irrational. And we’ve often said valuation is a blunt tool that may help tilt the probabilities in your favour, but it does not guarantee a certain desired outcome. We have a fun chart, which we’ll post, we’ll try to update it, of yearly CAPE value starting in 1900. It shows initial CAPE values and their respective future 10-year returns from those values. The dark green colours is the cheapest starting years, red is the most expensive. And as now, as you would expect, most of the red and yellow starting years, which are expensive, end up on the left side of the chart, meaning low future returns. But notice, some expensive starting years in markets still end up on the right side, meaning double-digit 10-year returns. Sometimes the drunk tourist makes his hand, but most of the time he will head back to his room with empty pockets. It works the other way as well.
Notice the handful of inexpensive green starting years that actually wind up posting anaemic 10-year returns. Any investor who’s been in the markets long enough won’t be surprised by this. Markets don’t always behave as we expect or want. But as the chart illustrates in the post, which we’ll post, while you can’t be certain of an outcome, you absolutely put the odds in your favour by investing in cheaper CAPE markets while avoiding expensive ones. Let’s circle back to detractors who claim CAPE doesn’t work on a single asset class. We just respectfully suggest that trying to use CAPE in that manner is misguided. The real value of CAPE or any value-based metric is when it’s applied to a global investment set, telling you which assets or markets are likely to treat your money the best. Think optimising a broader portfolio. CAPE’s value is non-predicting when a single asset class or market is gonna do all by itself in a vacuum.
But we’ve intended to illustrate, when you use CAPE in a broader logical way, the data seems to prove it’s a wonderful timing tool. Let’s wrap this up with a fun, slightly different way of tackling this. Two questions. First question. Would you rather invest in the cheapest stock markets in the world with an average CAPE Ratio of around 11 or the most expensive, with the value double that, in the mid-20s? It seems obvious. But given the content that many investors feel towards CAPE, let’s rephrase it. Would you rather invest in the cheapest stock markets in the world offering an average dividend yield of over 4% or the most expensive with the yield below 2%? If you believe CAPE is fundamentally flawed and useless, then you should find this distinction moot. But maybe putting CAPE’s real value into perspective is better accomplished with our second question. If you’re in Vegas, sitting on a 19 at the blackjack table, do you think you’ll win more often by asking for another card or staying with your existing hand?
This was a fun one, guys. Lots more resources. There’s my pin tweet on Twitter. @mebfaber has my 10 favourite valuation metrics and places that offer CAPE values, updated for free, places like Barclays, Star Capital, Research Affiliates and others, some of which you can download, some of which have much more evolved databases that you have to pay for, like global financial data, but plenty of resources which you can go play around with on your own as well. You can find resources…again, we’ll post show notes, a couple of these charts, mebfaber.com/podcast. Shoot us an email, give us some firstname.lastname@example.org. We’d love to hear from you, any ideas, thoughts, suggestions, criticisms, all that good stuff. Subscribe to the show on iTunes, Overcast, Stitcher, RadioPublic and Breaker. Thanks for listening friends, and good investing.