Can You esCAPE US Stock Returns?

Forecasting bond and stock returns is almost impossible to get right over short time horizons. But over longer time frames the methodology I used in my November 2021 blog Stock Return CAPEr: The Next Decade’s Returns has a good fit with the historical data, particularly the S&P 500. I last updated the estimated returns for US and Canadian stocks in January 2023. Since then, the S&P 500 has been on a terrific run, up 40% in Canadian dollars. Does that mean there is no esCAPE from lower returns over the next 10 years?

In Case You Are Interested: Data

As a quick review, the price earnings ratio (P/E) is calculated by dividing the share price of a company or the level of a stock index by its earnings per share (EPS). EPS is essentially net income over the last 12 months divided by the number of shares outstanding. A higher-than-average P/E is one way of estimating that a stock or index is priced above fair value. On the flip side, a lower-than-average P/E indicates the price may be below fair value. The level of P/E’s are inversely related to interest rates.

The methodology I used is based on the CAPE (cyclically adjusted price-to-earnings) ratio, popularized by Professor Robert Shiller. The data covers the 20 years to June 2024.

US Stock Returns

Chart 1 is the same as in the previous blogs, with the addition of the orange dot plotting the CAPE as of June 2024 and the green dot plotting the CAPE as of January 2023. The chart shows, for each monthly S&P 500 (US stocks) CAPE ratio, the resulting annualized 10-year return for the S&P 500 (blue diamonds). The estimated 10-year returns for the monthly CAPE ratios (black squares) is based on a regression of the historical returns and CAPE ratios over the 20 years to June 2024.

At the time of the January 2023 blog the CAPE was 29 (green dot), which was down from 37 at the time of the original blog in November 2021. This meant that the estimated 10-year annualized return for the S&P 500 went up significantly, from 2% to 6%, with a range of 3% to 9%. The opposite has happened now with the CAPE moving up to 35 (orange dot). This means the estimated 10-year annualized return has gone down significantly to 3%, with a range of -1% to 7%.

Chart 1

Canadian Stock Returns

Chart 2 updates the Canadian data. The red diamonds show the subsequent 10-year returns for each monthly S&P/TSX (Canadian stocks) CAPE level. The black squares are the estimated 10-year returns from a regression of the historical returns and CAPEs over the 20 years to June 2024.

The data for Canada shows a much different story from the US. The CAPE decreased slightly, from 22 in January 2023 to 21 currently. Not surprisingly, the return on Canadian stocks was only 10% from January 2023 to June 2024, vs 40% for US stocks. The good news looking forward is that the estimated 10-year annualized return is 8%, with a range of 5% to 11%.

Chart 2

You Can esCAPE

US 10-year estimated annual returns have dropped to a paltry 3% as the CAPE has increased to 35. But you can esCAPE to Canadian stocks in the search for higher expected returns of 8% due to the much lower CAPE of 21. Based on the CAPE methodology, holding a significant portion of your portfolio in Canadian stocks is a good strategy. As I said in the last CAPE blog, keep in mind that these are long term forecasts and stocks fluctuate significantly over the shorter term.

Invest Wisely,

Dave Schaffner, CFA Principal, Wayfairer Capital Management Ltd.