[quote=ucodegen][quote=henrysd]
CAPE is only one measurement of stock market valuation just like SAT test scores used in college admission. It has serious flaw – it fails to consider the interest rate. Early 80 CAPE can’t compared with current time CAPE due to 10% difference in interest rate. Vanguard uses a modified version of CAPE called fair-value CAPE and adjust for current interest rate. In Vanguard research, current U.S. stock market is still considered overvalued, but only slightly due to low interest rate. This is in sharp comparison with many other pure CAPE modelers: https://vanguardblog.com/2019/03/13/what-fed-projections-may-mean-for-longer-term-stock-returns/
Contrarian view is negative stock marker sentiment is bullish for stocks. For the last half year the sentiment was mostly bearish with all the recession talk. Wall street would love to propel the market higher when so much retail investor money has sidelined.[/quote]
When considering valuation, not only do you need to consider the current interest rate, you also need to consider what ‘likely’ future interest rates may be and rates of inflation. Treasuries are not inflation protected unless you are picking up TIPS(Treasury Inflation Protected Securities). TIPS will tend to yield lower than standard treasuries. Most people consider treasuries to be safer than stocks, but that is not necessarily true unless you are holding to maturity.
Interest rate risk At the current (11/6/2019) yield of 2.3%, they are an extreme form of leverage. The SEC has a good short publication on the interest rate risk on treasuries. Basically the price difference(possibly discounted) will be based upon both where the current yield curve is as well as the difference on the Coupon Rate vs Market Interest Rate of the Treasury. A 30 year held for 10 years then sold is basically a 20 year Treasury when sold. If the rates are the same in 10 years as now, you would be selling a 2.3% yielding ’20’ year treasury in a market where current 20 years are yielding 2.13%. You would be able to sell at a premium. However if the interest rate increases before selling and the 20 year treasuries are yielding 3%, you will have to sell for less than the face value.
Inflation Only TIPS are inflation protected. On a non inflation protected ‘standard’ treasury, if it is yielding 2% while inflation is 1.5%, your actual gain is 0.5% because the tangible value of the treasury will have dropped by 1.5% while you were paid 2%. This is where boring dividend stocks have a potential advantage. The price of the stock, its revenue, its earnings and its dividends will tend to also increase by the rate of inflation while the treasury has remained the same.
To get a rough look of Stocks vs Treasuries, you can invert the PE ratio (provided the stock actually has earnings) and it gives you a rough idea of internal ‘yield’. A PE ratio of 30 would be a return of around 3.33% – held internal to the company if there are no dividends. PE represents P/E for the stock, E/P is effectively a yield. Of course stocks also have a risk in a increasing interest rate environment because of the rough equivalence yield to Treasury Rate.
NOTE: Using Black Tuesday 1929 as a guide for the ‘watch out’ PE is not a good idea. There was a lot more that went into causing Black Tuesday’s crash and the depression than just PEs. The financial accounting standards in 1929 were — well you could call it the Wild West… the NINJA equivalent to the mortgage crisis.[/quote]
Thanks for the response. It’s great to see some posts that use data. I understand that interest rates have a big influence, but the interesting question is: how do you work them into the valuation model for stocks?
Anecdotally I’m seeing more friends and neighbors living beyond their means. It’s not as much about real estate, but cars, swimming pools, vacations, etc. The data seems to back up my observations. I don’t think the data points to a crash, but I do think it suggests that the economy is going to slow down as the current level of consumer spending is not sustainable.
