High CAPE ratio levels do not signify an imminent end to the bull market. But they do sound a note of caution.
The cyclically adjusted price-to-earnings ratio, commonly known as the CAPE ratio, recently reached levels seen on the US stock market in 1929, sparking renewed fears that global equity markets could be ripe for a correction. But this may not be the case. As Nobel prize winner Robert Shiller – one of the fathers of the CAPE ratio – indicated earlier this year, equity markets could remain bullish for years.
The CAPE ratio is a valuation measure of the stock market that can be defined as stock prices divided by the moving average of ten years of earnings per share, adjusted for inflation. It is a widely followed measure, usually applied to broad equity indices to assess whether the market is under- or overvalued.
But a closer look at the relationship between CAPE ratios and equity returns shows that the CAPE ratio is a poor predictor of market performance. An analysis of US stock market data for the period 1929-2018 reveals only a weak negative relationship between the CAPE ratio and the subsequent three-year equity returns adjusted for inflation.
The expected three-year equity returns over the entire sample period is lower when the CAPE ratio is high and, generally speaking, enters negative territory when CAPE ratios are very high (above 30). However, there is also quite some variation in returns, with considerable losses visible for CAPE ratios of around 25, and solid returns for CAPE ratios of around 30.
But while the CAPE ratio may not be a very reliable indicator for predicting market reversals, it can definitely help assess downside risk. Our research shows that higher CAPE ratios are typically followed by periods with higher downside risk, as measured by the lower partial moment (LPM), which is calculated by multiplying the probability and magnitude of an expected loss. This pattern has been visible not just for US equities over the past 90 years but also, more generally, in global developed and emerging stock markets.
High CAPE ratios do not, therefore, signify an imminent end to the bull market, but they do sound a note of caution about downside risk. The good news for investors is that they can reduce this risk substantially by tilting their equity portfolios towards low-risk stocks. A simulation using a simple low-risk investment formula, dubbed the ‘Conservative Formula’,1 in a universe of 1,000 large US stocks shows that the risk of losing money can be reduced significantly – even when CAPE ratio levels are high.
The Conservative Formula divides the investment universe into two equally sized groups based on the historical volatility of returns over a three-year period. Within the group of 500 lower-volatility stocks, it selects the 100 most attractive stocks based on net-payout-yield (NPY) and price momentum. We refer to this defensive equity style as ‘conservative’.
Our calculations show that using this simple investment formula significantly reduces the chance of losing money on the stock market over 3-, 12-, 36- and 60-month investment horizons. Moreover, the Conservative Formula also proves to be very effective at reducing downside risk, as measured by the LPM, when CAPE ratios are high. For example, the three-year downside risk is reduced significantly, from -15% to -2%, when the CAPE ratio is above 25. Figure 1 shows this reduction of downside risk compared to the broader equity market, across different CAPE ratio ranges.
As the summer of 2018 begins, equity markets remain at or near all-time highs and volatility is low. This might be a good moment for investors to take a strategic look at their long-term investment portfolio and consider a more ‘conservative’ approach.
1Blitz, D. and Van Vliet, P., ‘The Conservative Formula: Quantitative Investing Made Easy’, March 2018.
The contents of this document have not been reviewed by the Securities and Futures Commission ("SFC") in Hong Kong. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. This document has been distributed by Robeco Hong Kong Limited (‘Robeco’). Robeco is regulated by the SFC in Hong Kong.
This document has been prepared on a confidential basis solely for the recipient and is for information purposes only. Any reproduction or distribution of this documentation, in whole or in part, or the disclosure of its contents, without the prior written consent of Robeco, is prohibited. By accepting this documentation, the recipient agrees to the foregoing
This document is intended to provide the reader with information on Robeco’s specific capabilities, but does not constitute a recommendation to buy or sell certain securities or investment products. Investment decisions should only be based on the relevant prospectus and on thorough financial, fiscal and legal advice. Please refer to the relevant offering documents for details including the risk factors before making any investment decisions.
The contents of this document are based upon sources of information believed to be reliable. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.
Investment Involves risks. Historical returns are provided for illustrative purposes only and do not necessarily reflect Robeco’s expectations for the future. The value of your investments may fluctuate. Past performance is no indication of current or future performance.
Please read this information carefully.
This website is prepared and issued by Robeco Hong Kong Limited ("Robeco"), which is a corporation licensed by the Securities and Futures Commission in Hong Kong to engage in Type 1 (dealing in securities); Type 4 (advising in securities) and Type 9 (asset management) regulated activities. This website has not been reviewed by the Securities and Futures Commission or any regulatory authority in Hong Kong.
2. Important risk disclosures
2. Important risk disclosures Robeco Capital Growth Funds (“the Funds”) are distinguished by their respective specific investment policies or any other specific features. Please read carefully for the risks of the Funds:
3. Local legal and sales restrictions
The information contained in the Website is being provided for information purposes.
Neither information nor any opinion expressed on the Website constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service. The information contained in the Website does not constitute investment advice or a recommendation and was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. An investment in a Robeco product should only be made after reading the related legal documents such as management regulations, prospectuses, most recent annual and semi-annual reports, which can be all be obtained free of charge at www.robeco.com/hk/en and at the Robeco Hong Kong office.
4. Use of the Website
The information is based on certain assumptions, information and conditions applicable at a certain time and may be subject to change at any time without notice. Robeco aims to provide accurate, complete and up-to-date information, obtained from sources of information believed to be reliable. Persons accessing the Website are responsible for their choice and use of the information.
5. Investment performance
No assurance can be given that the investment objective of any investment products will be achieved. No representation or promise as to the performance of any investment products or the return on an investment is made. The value of your investments may fluctuate. The value of the assets of Robeco investment products may also fluctuate as a result of the investment policy and/or the developments on the financial markets. Results obtained in the past are no guarantee for the future. Past performance, projection, or forecast included in this Website should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. Fund performance figures are based on the month-end trading prices and are calculated on a total return basis with dividends reinvested. Return figures versus the benchmark show the investment management result before management and/or performance fees; the fund returns are with dividends reinvested and based on net asset values with prices and exchange rates of the valuation moment of the benchmark.
Investments involve risks. Past performance is not a guide to future performance. Potential investors should read the terms and conditions contained in the relevant offering documents and in particular the investment policies and the risk factors before any investment decision is made. Investors should ensure they fully understand the risks associated with the fund and should also consider their own investment objective and risk tolerance level. Investors are reminded that the value and income (if any) from shares of the fund may be volatile and could change substantially within a short period of time, and investors may not get back the amount they have invested in the fund. If in doubt, please seek independent financial and professional advice.
6. Third party websites
Following links to any other off-site pages or websites of third parties shall be at the own risk of the person following such link. Robeco has not reviewed any of the websites linked to or referred to by the Website and does not endorse or accept any responsibility for their content nor the products, services or other items offered through them. Robeco shall have no liability for any losses or damages arising from the use of or reliance on the information contained on websites of third parties, including, without limitation, any loss of profit or any other direct or indirect damage.
7. Limitation of liability
Robeco as well as (possible) other suppliers of information to the Website accept no responsibility for the contents of the Website or the information or recommendations contained herein, which moreover may be changed without notice.
Robeco assumes no responsibility for ensuring, and makes no warranty, that the functioning of the Website will be uninterrupted or error-free. Robeco assumes no responsibility for the consequences of e-mail messages regarding a Robeco (transaction) service, which either cannot be received or sent, are damaged, received or sent incorrectly, or not received or sent on time.
Neither will Robeco be liable for any loss or damage that may result from access to and use of the Website.
8. Intellectual property
All copyrights, patents, intellectual and other property, and licenses regarding the information on the Website are held and obtained by Robeco. These rights will not be passed to persons accessing this information.
10. Applicable law
The Website shall be governed by and construed in accordance with the laws of Hong Kong. All disputes arising out of or in connection with the Website shall be submitted to the exclusive jurisdiction of the courts of Hong Kong.