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Sunday, March 26, 2017

The 4 strongest arguments for a big bear market (and why all are wrong) Part 1

Valuation by Shiller PE:
This is one of the strongest arguments for a bear market. The CAPE or Shiller P/E ratio which calculates the  P/E ratio by taking the inflation adjusted earnings over the last decade, is currently around 30 (this is an older chart but it shows fantastic info so I used it).  Periods when CAPE was over 22 are shaded. What it does show is that in general; stocks have a hard time making much progress when CAPE is that high.

Periods of elevated CAPE are from
1986 to 1910
1968 to 1982
and 1996 to virtually all the way to today with a brief interlude in between.
Also this chart is the total return index as in the value of investment with dividends reinvested. This shows that in spite of dividends reinvested, the total return is definitely weaker in those periods.

But anyone using CAPE alone is missing the big picture. As the second chart shows, stocks have returned on average 1% after inflation even during elevated CAPE. 

But the range is astronomical. If you expect 4% inflation average over the next 10 years, your total nominal returns on stock could be a -10% to 120%. You could certainly lock in a guaranteed 27% in a 10 year bond for part of the portfolio and current yield jump certainly makes bonds a lot more appealing than they were before.
By itself CAPE/Shiller P/E suggest that the markets will likely not make large inflation adjusted headway in the years to come. But the range is so huge that it is next to useless as a forecasting tool and certainly no guarantee that the bull market is ending.

Stocks will still beat bonds (most likely) if we have moderate to high inflation.
Shiller P/E is the reason though that I am heavily underweight US in my portfolio and have all my long term holdings in REITS and Energy. Both sectors are heavily out of favour and many REITS where I have the lion’s share of the portfolio are trading at single digit multiples.  

To be continued....

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