CAPE Fear: Markets Heading Downhill – But Not Management Fees


You may have heard about the Cyclically Adjusted Profit Earnings ratio, (or CAPE), which has a near uncanny ability to predict huge periods of market volatility in recent years.

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Created by Dr. Robert Shiller, a Yale University economist (thus the term the “Shiller Ratio” to describe CAPE among Wall Street professionals), CAPE measures the S&P 500 Index from 1871 to the current day to benchmark future stock market activity. 

Basically, the CAPE formula is this - the current price of the index divided by the average earnings per share for the previous ten years adjusted for inflation. 

The CAPE is framed to estimate likely future returns from stocks over of 10 to 20 years, with higher CAPE estimates linked to lower than average long-term annual average equity returns. Economists note the index isn’t specifically designed to predict future stock market collapses (or market upturns), but CAPE’s track record has been spot on in identifying market trends in recent years, usually a year ahead of time.

Here’s a look at annual CAPE figures dating back to 2003:

Year CAPE        Calculation

January, 2003        22.89
January, 2004        27.65
January, 2005        26.58
January, 2006        26.46
January, 2007        27.2
January, 2008        24.01
January, 2009        15.17
January, 2010        20.52
January, 2011        22.97
January, 2012        21.21
January, 2013        21.9
January, 2014        25.4
January, 2105        27.2

In 2007, the CAPE Ration measured 27.2, signaling trouble in the stock market, which is exactly what happened in 2007 and 2008, when the S&P returned 5.49% and -37.0%, respectively.

But in 2009, the CAPE fell to 15.17, which signaled a market upturn, which occurred as the S&P 500 returned 26.46% and 15.06% in 2009 and 2010.

So with the CAPE back up over 27% in January, 2015, are we in for stock market that will skid downwards?

Some smart market gurus think so.

Former Morningstar equities analyst John Coumarianos, writing in Marketwatch recently http://www.marketwatch.com/story/if-you-hope-to-have-enough-money-later-youd-better-save-more-now-2015-02-06, believes investors should take the CAPE ratio seriously.

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“Stocks will probably lag in the coming decade, because they are historically expensive on a valuation metric called the “cyclically adjusted price/earnings ratio” or CAPE. Stocks and bonds appear poised to deliver lower returns than they have,” he writes. “And, of course, cash currently yields nothing, guaranteeing a negative real or inflation-adjusted return for the time being.”

“Investors might think the strongest response to this situation is to take more risk. But taking extra risk in markets that already seem overpriced could result in severe losses. Instead, you must save more to meet financial goals,” he adds.

It’s important to understand the CAPE was not designed to predict one-year market returns, although it has been remarkably prescient about tying high index estimates to down markets. But analysts at Vanguard and AOR Capital Management are also predicting a long-term market slowdown (or worse) and that could leave, as Coumarianos, puts it, needing to save more to make less.

That’s where a particular source of frustration enters the picture – high investment advisory fees that don’t decline just because the market does, or decline because you have to save more money to keep up your savings rate for retirement.

Make no mistake, investors tend to be acutely aware of what they’re shelling out in investment fees at the precise period when they’re most sensitive to their household budgets during declining economies and downward-performing stock markets.

Financial advisory firms may be sensitive to that, but don’t expect them to “share the pain” and cut fee rates if, as many experts and CAPE indicate, and the stock market underperforms.

A 2012 study from Morningstar estimates the “added value” of a financial planner is worth an additional 1.82% annually in portfolio performance. That might pass muster if the stock market is up 20% for a given year. But a steady diet of low-single-digit, or even negative portfolio performance, when advisors are getting 3% or so in annual fees, won’t cut it with investors.

If the CAPE scenario transpires, don’t expect advisory fees to decline. Because advisors just won’t cut those fees, even as their clients dig deeper to save for the long-haul – with no fee break in sight.

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