One of our models is a “calculating CAPE” from macroeconomic fundamentals approach. The model did a magnificent job of highlighting the “tech wreck” overvaluation, and likely did so again in the current inflationary environment.
We are taking a cyclically adjusted price earnings ratio, and trying to forecast its intrinsic or fundamental value based on macroeconomic inputs.
We know that under certain assumptions, an earnings yield can be expressed as a real risk free rate, plus a risk premium minus an estimate for earnings growth.
Here, we use CBO’s potential output growth YoY as a proxy, and use the natural rate of interest (r*) as the long run real rate input.
You’ll note we also show inflation, I’ll come to that in a moment.
Economic theory suggests there is a relationship between the interest rate and growth, and we can model that below using a 3rd order polynomial (detail doesn’t matter).
Given a long run view on potential output growth, we can then model the long run r* over time.
We are now ready to predict our intrinsic or fundamental CAPE value. Note the below statistically significant correlates – right sign, right magnitude.
Why does inflation appear? Aren’t CAPE’s adjusted for inflation in both denominator and numerator? Why does the impact of inflation still clearly comes through?
It is because analysts often mark up the rising interest rate, in their models, easily enough, but not the revenues that go with them (causing stocks to be undervalued, often, in high inflation environments) and mark down the declining interest rate, in their models, easily enough, but not the revenues that go with them (causing stocks to be overvalued, often, in low inflation environments).
That’s what the regressions detect.
The net result was a Shiller PE that once again looked crazy overvalued relative to market, a clear DAA market timing device.
Of course it is just one model, and we didn’t expect persistent inflation in the first place, but if you had, this is exactly the model you would weight more heavily, in your process.
As it was, we were some 600bps UW equities, at the DAA level, in our direct equity portfolios, and some 400bps UW fixed income, in a moderately defensive position ahead of the now famous “Fed hawkish pivot” of November last year.
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