Tech Changes Margins And Renders Monetary Policy Useless

When investors first look at the CAPE ratio there is an incredible realization that it has a great track record of predicting long-term returns. You can see the 5 year IRR versus the 5-year CAPE in the chart below. Since the S&P 500 10-year CAPE is at 33.35, which is very high, long-term returns are projected to be very low.

Source: chart below

One obvious flaw in the CAPE ratio is that even though it uses data since the 1870s, there has only been one other market with such a high ratio which was the 1990s tech bubble. You can see the rareness of the current 5-year CAPE in the top left chart below. Using just one cycle to make an argument isn’t great and doesn’t stand the test of time.

Source:  top left

Countering that point is that even though the CAPE ratio has rarely been this high, we can use the relationship between CAPE and returns to assume high rates equal low returns. The problem with that point is the CAPE ratio has been rising in the past few decades as stocks only shortly fell below the median CAPE ratio which started this current bull market which is the longest in history. The median ratio is 15.66. Stocks were below that valuation from November 2008 to April 2009. The worst recession since the Great Depression put valuations below the median for only 6 months.

Technically, followers of CAPE would say stocks should almost always be bought except when the CAPE ratio is very high like now. While that’s a fair point, the fact that the Shiller PE has been higher than its historical median for most of the past few decades seems to suggest there have been changing market dynamics which make it less relevant.

Source: Shiller PE

The biggest assumption CAPE makes is that margins will fall. There’s debate whether this is cyclical action or mean reversion. Either way, the current record margins are projected to decline. Investors fear when anyone says ‘this time is different’, but it’s fair to question if the high margins the tech sector has produced must fall just because margins in other industries did so in the past.