Time to get defensive?

Time to get defensive?

12-11-2018 | 5-Year outlook

It’s one of the best-known acronyms in finance – and it remains a good indicator of where stocks might go. CAPE suggests that it is time to focus on your defensive capabilities, says portfolio strategist Jaap Hoek.

  • Jaap Hoek
    Portfolio Strategist

Speed read

  • CAPE ratio is at levels seen before the Great Depression and bubble
  • Modelling suggests a high probability that losses are coming
  • Different portfolios would weather the potential storm differently
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In last year’s Expected Returns, we shared our concerns about the valuation of the markets, and of the US equity market in particular. Since that time, the market has set new records, and although it has seen its first correction, addressing price concerns remains high on our agenda.

The Cyclically Adjusted Price-Earnings (CAPE) ratio, is one of our favorite tools for assessing equity market valuation. The ratio was first introduced in an article by economists John Y. Campbell and Robert J. Shiller published in 1988. It compares the latest market price – often measured by a popular stock index such as the S&P 500 – with past earnings.

For the latter, Campbell and Shiller suggest using a 10-year average, whereby the past earnings are inflated to the latest price level. In this way, the measure can be used to compare the current price with a ‘business as usual’ earnings estimate over the course of a business cycle.

Campbell and Shiller showed that their CAPE ratio was able to explain about a third of the variation (positive or negative) in the subsequent inflation-adjusted 10-year stock market returns in the US. A low CAPE ratio can be considered a predictor of relatively high returns, while a high ratio is thought to foreshadow relatively low returns.

The CAPE ratio has become very popular since Shiller warned of overvalued stock markets in his well-known book: Irrational Exuberance, published in 2000 a year before the dot-com crisis broke out. Ever since then, the market has kept a close eye on the ratio, and an ear out for Shiller’s guidance.

A troubling message since 2017

Since 2017, the CAPE ratio has been sending a troubling message, after reaching levels only seen previously in the run-up to the Great Depression and dot-com bubble. This offers us insight into the losses investors might suffer if history repeats itself.

The graph below plots the relationship between the Shiller CAPE and the subsequent 5-year real returns for the S&P 500, clearly showing that the higher the CAPE, the larger the subsequent losses. With CAPE at its current levels, this suggests that losses over the next five years could potentially be considerable.

The relationship between Shiller CAPE and the subsequent 5-year real returns for the S&P 500.
Source: R. Shiller & Robeco

This raises the question as to whether investors should reallocate a portion of their equity holdings, an issue that is particularly relevant for risk-averse investors. To answer this question, we performed an analysis focusing on the downside risk. We compared three equity portfolios – market neutral, low-risk and high-risk – with a balanced portfolio that invests 70% in equities and the remaining 30% in a 10-year US Treasury.

Plotting the probability of losses

The low-risk portfolio consisted of the 300 stocks that had the lowest volatility, while the high-risk portfolio contained the 300 stocks with the highest volatility. We then used our quantitative techniques to focus on the downside risk of the portfolios. This plotted the probability of there being a negative real return within a period of five years.

Given the current high level of the CAPE, we looked at historical data corresponding with the CAPE being in the top quintile, though only focused on the downside risk of the portfolios. The probability of a real loss in subsequent five-year returns was very high for the market and high-risk portfolios. The probability was highest for the market portfolio, though the high-risk portfolio remained the riskiest. This can be seen by combing the probability with the average loss to create an indicative tool called the Lower Partial Moment (LPM). This is shown in the table below:

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Results for portfolios based on the US stock market and US 10-year Treasury, 1929-2017, in the top CAPE quintile.
Source:, R. Shiller, Federal Reserve, Robeco

Clear warning for the risk-averse

We see the results of the table as a clear warning for risk-averse investors – that losses in this high CAPE environment are probable, and that they can be material. Note that the risk characteristics of a low-risk equity or balanced portfolio have been much better.

But there is a caveat: when CAPE reached 1929 levels in 2018, Shiller not only expressed his concerns about the valuation, but also wisely stated that markets could remain bullish for years to come. While a loss looks highly probable, it is almost as likely that returns will remain in positive territory within the five-year timespan.

Still, investors and especially risk-averse investors are well-advised to focus on downside risk for the coming five years, and to see which portfolio will weather the potential storm best.

Expected Returns 2019-2023
Expected Returns 2019-2023
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