What Famed Economist Robert Shiller Sees in ‘Vexing’ Stock Market Rebound

Is the equity market recovery during the pandemic justified?

Andrey Rudakov/Bloomberg

Andrey Rudakov/Bloomberg

The fast recovery of equities markets has left valuations in the U.S. appearing the most expensive globally, according to Nobel-prize winning economist Robert Shiller and co-authors in a recent paper.

The “vexing” rebound during the Covid-19 pandemic — before a vaccine has been found — has been driven by the healthcare, technology, and the communication-services sectors. Shiller, who teaches at Yale University, teamed up with Laurence Black of The Index Standard and Barclays’s Farouk Jivraj on the October 19 paper. The stock market recovery may be partly explained by the tech and telecom booster of working from home, as well as low interest rates, they said.

For their study, the researchers used the cyclically-adjusted-price to earnings (CAPE) ratio developed by John Campbell and Shiller more than three decades ago “to characterize the strong relationship between an inflation adjusted earnings-price ratio and subsequent long-term returns.” They also created an “excess CAPE yield” to measure returns above the 10-year interest rate yield across the U.S., China, Japan, Europe, and the U.K.

“The U.S. equity market, in particular, has had one of the quickest recoveries in history and remains the most expensive with its CAPE ratio above its long-term average,” Shiller, Black, and Jivraj wrote. “The others remain at or below their long-term CAPE averages... Across the five equity markets the CAPE level has risen back by varying degrees to pre-pandemic heights.”

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The authors studied the behavior of the CAPE ratio as it is a widely followed measure of long-term equity market valuations that Shiller and Campbell first highlighted in their 1988 paper on stock prices, earnings, and expected dividends. Ten-year rates and the “excess CAPE yield” developed by the authors of this month’s paper may explain the market rebound in the pandemic.

“With rates so low, the excess CAPE yield across all regions is almost at all-time highs, indicating that relative to bonds, equities appear highly attractive,” they said.

The U.S. CAPE ratio at the end of September 2020 was 32 based on the benchmark MSCI USA index, rising from a low of 23 in late March.

The ratio has “surprisingly retraced” to the level seen in January 2018, well before the pandemic, according to the paper. “We have only seen two periods in available history where the CAPE ratio has been above 30, namely the 1920’s prior to the Great Depression and in early 2000 as the Nasdaq bubble peaked,” the authors said. “Even during the 2007/2008 financial crisis, the CAPE ratio did not exceed 30.”

The historical average of the U.S. CAPE ratio since 1881 is 17, according to the paper. Over the past two decades, the measure has been more elevated at around 25.6, the researchers said.

That’s one way of looking at the market.

Larry Cordisco, co-chief investment officer of Osterweis Capital Management’s core equity strategy, is more focused on the future earning power of companies than the backwards-looking CAPE ratio. The CAPE is based on the average of the last 10 years of inflation-adjusted earnings, according to the paper.

The stock market is “expensive in pockets,” Cordisco said Tuesday in a phone interview. He said he likes companies whose earnings and valuations have fallen in the pandemic — but are poised to bounce back when a vaccine becomes available, citing Ross Stores and Sysco as examples.

Ross Stores, which sells women’s apparel at discounted prices, and food-service company Sysco are part of Osterweis’s portfolio, according to Cordisco. They are among the stocks he has viewed as not “unreasonably priced,” based on earnings multiples and their potential for a comeback from the pandemic.

Investors have been looking past the turmoil this year and through a portion of 2021 as part of a “reopening trade,” tied to the expectation of the arrival of a vaccine and therapeutics for Covid-19. “These are things that are giving the market a lot of confidence that it’s transitory,” he said.

Cordisco estimated that the reopening trade could press on until “mid-to-late spring,” at which point investors may start to worry about being “behind schedule” for ending the economic devastation inflicted by the pandemic. “Then you got a tougher environment,” he said.

In their paper, Shiller, Black, and Jivraj said it’s probably too soon to “gauge the impact of decreases in corporate earnings” since the pandemic began. Meanwhile, forecasted equity returns have risen, except for in the U.S., where the CAPE ratio has returned to pre-Covid levels, they said.

“We also produced forecasts of excess equity returns over bonds, as it is important to consider the extremely low level of interest rates,” the researchers wrote. “We examined the role of this dynamic across the term structure of expected excess returns.” The so-called term structure refers to forecasts over a two-year, five-year, and 10-year horizon, according to the paper.

“With respect to forecasted excess equity returns over bonds, it is clear that the term-structure has widened in the short end as a result of the pandemic, most noticeably in the U.S. and the U.K.,” the authors wrote. Their analysis found the “term structure” kept relatively stable in Europe and Japan.

“Their valuations have recovered or exceed their pre-pandemic levels, with the U.S. remaining somewhat expensive and Japan remaining somewhat cheap,” the authors said.