Robert Arnott Slides

King of the Mountain:
Finding Short-Term Efficacy in the
Shiller P/E Ratio
Rob Arnott
Chairman
Oct 19, 2015

King of the Mountain

»CAPE in forecasting subsequent returns
  â€ºPowerful at forecasting long-horizon returns
  â€ºLess so for short-horizon returns

» CAPE and macro regimes
  â€ºLink with real interest rate and inflation
  â€ºThe 3-D valuation mountain

» Application
  â€ºPotential of forecasting short-term returns

CAPE in forecasting subsequent returns

Valuation Ratios Mean Revert at Long-Horizon

»Low (high) PE implies high (low) future returns

roberts

High Stock Valuations Produce Lower Returns

CAPE vs. Subsequent 10-year Real Returns: January 1990 –June 2015, United States

roberts1

Same Relationship in EM Equities

CAPE vs. Subsequent 10-year Real Returns: January 1990 –June 2015, EM

roberts2

EM Risk is Priced Again

Relative Valuation Ratios vs Relative Subsequent Returns: January 1990 –June 2015

roberts3

CAPE is Powerful at Forecasting Long-Horizon Returns, Less So for Short-Horizon Returns

roberts4

CAPE is Powerful at Forecasting Long-Horizon Returns, Less So for Short-Horizon Returns

roberts5

CAPE is Powerful at Forecasting Long-Horizon Returns, Less So for Short-Horizon Returns

roberts6

CAPE Varies Across “Growth Cycle”

»High valuation may be justified under the right conditions

roberts7

The essence of our research: adding one illustrative measure of economic condition to enhance our understanding of the mean-reversion target for CAPE

CAPE and Macro Regimes

Link Between CAPE and Real Interest Rates

»Median CAPE plummets when…
  â€ºReal interest rate is negative → reflecting a desire to aggressively stimulate the economy, or
  â€ºReal interest rate unusually high → reflecting a desire to rein in an overheated economy
Median P/E at Different Real Yield* Regimes (United States, 1880.12–2013.12)

roberts8

Link Between CAPE and Inflation

»Median CAPE alsoplummets when…
  â€ºInflation is unusually high → increased money supply without growth
  â€ºInflation is zero or negative → decreased price leads to lower production

Median P/E at Different Inflation* Regimes (United States, 1880.12–2013.12)

roberts9

Why these results matter? Fed policy intends to depress interest rates for as long as inflation remains low

The Macroeconomic Sweet Spot for A Soaring CAPE

»Common belief: rock-bottom levels of inflation and real interest rates
»3-D valuation mountain: moderate levels of inflation and real interest rates

Median P/E at Different Inflation and Real Yield Regimes (United States, 1880.12–2013.12)

roberts10

A Nonlinear Model Based on the Valuation Mountain

roberts11

Use Gaussian Model to Fit a Continuous Function

»Polynomials are simple, but are not bounded
»Gaussian function is a better alternative

roberts12

Gaussian Model Surface Curves

»The “sweet spot” for CAPE in U.S. equity market
  â€ºLow inflation (~1.5%)
  â€ºModerate real interest rate (~3%)

roberts13

Gaussian Model-Statistical Fit

»Traditional OLS has poor fit(and occasionally wrong sign)
»Gaussian model(3-D Mountain) has an R2 of 50.7%

roberts14

Application:Improving Return Forecasts

Forecasting Returns with CAPE and Modeled CAPE United States, 1880.12–2013.12

»CAPE is more powerful in forecasting long-horizon returns
»Adjusted CAPE enhances short-term return forecast

roberts15

Intuition of Observations

»CAPE is a strong predictor for long-horizon (5-10 years) returns
  â€ºLong-term valuations mean-revert, with high statistical significance

»CAPE is a weak predictor for short-horizon (up to 3 years) returns
  â€ºCurrent macroeconomic environment affects normal CAPE
    â€ºProvides better estimate of fair market valuation
    â€ºLeads to better ability to forecast returns at short-horizon
    â€ºImproves results shorter than 3 years in U.S.
  â€ºCurrent CAPE does not matter, except relative to model CAPE

»Transitioning from short to long horizon
  â€ºUsefulness of “current” macroeconomic variables fades
  â€ºThe macroeconomic environment in 5-10 years will differ from today

Global Markets

Link Between CAPE and Real Interest RateDeveloped Countries (excluding U.S.)

»Remarkable similarity to what we observe in U.S. equity market

Median P/E at Different Real Yield* Regimes (Developed Countries, 1972.03–2013.12)

roberts16

Link Between CAPE and InflationDeveloped Countries (excluding U.S.)

»Weaker mountain-shaped relationship due to fewer episodes of very low inflation in the international sample

Median P/E at Different Inflation* Regimes (Developed Countries, 1972.03–2013.12)

roberts17

Observe Similar Valuation Mountain in Developed Countries (excluding U.S.)

»Common belief: rock-bottom levels of inflation and real interest rates
»3-D valuation mountain: moderate levels of inflation and real interest rates

Median P/E at Different Inflation and Real Yield Regimes (Developed Countries, 1972.03–2013.12)

roberts18

Gaussian Model –Surface Curves

Developed Countries (excluding U.S.), 1972.03–2013.12
»Near-identical location of the “Sweet Spot”

roberts19

Gaussian Model –Surface Curves

Developed Countries (excluding U.S.), 1972.03–2013.12
»Near-identical location of the “Sweet Spot”

roberts20

Gaussian Model –Statistical Fit Developed Countries (excluding U.S.), 1972.03–2013.12

»Few episodes of low inflation:good fit with inflation regression
»Gaussian model(3-D Mountain) has an R2 of 29.9%

Statistical Fit of Various Models Used to Explain P/E (Developed Countries, 1972.03–2013.12)

roberts21

Forecasting Returns with CAPE and Modeled CAPE Developed Countries, 1972.03–2013.12

»Similar to the U.S sample
»Significant increase in forecasting power at short horizons

roberts22

Valuation Matters…Even for the Intermediate Term

»Understanding CAPE in a more comprehensive way
  â€ºA 3-D valuation mountain better describe fair value of CAPE

»Finding the ―Sweet Spotâ€- for Equity Market Valuations
  â€ºStock prices can be high under the right condition
  â€ºModerate inflation and real interest rate are ideal
  â€ºToday’s conditions are not in that sweet spot, but QE is arguably a special kind of easy money, perhaps fueling asset bubbles.

»Application of the 3-D mountain valuation model
  â€ºValuations matter –not just in the long term, but in the short term
  â€ºIncorporating macroeconomics conditions significantly increases short-term return forecasting power

Appendix

Current Implications

»If current real rates were natural, not a consequence of QE
»… and, if the resulting real bond yields were natural
  â€ºThe natural valuation levels would be lower than today, by a wide margin.

roberts23

A 3-D Valuation Mountain CAPE vs. Real Interest Rate and Inflation

»What are the ideal macroeconomic conditions for a soaring CAPE?
  â€ºCommon belief: rock-bottom levels of inflation and real interest rates
  â€º3-D valuation mountain: moderate levels of inflation and real interest rates

Median P/E at Different Inflation and Real Yield Regimes (United States, 1880.12–2013.12)

roberts24

A 3-D Valuation Mountain Developed Countries (excluding U.S.)

Median P/E at Different Inflation and Real Yield Regimes (Developed Countries, 1972.03–2013.12)

roberts25

Important Information

• By accepting this document you agree to keep its contents confidential. You also agree not to disclose the contents of this document to third parties (including potential co – investors) without the prior permission of Research Affiliates, LLC (Research Affiliates, including its related entities).

• Research Affiliates, LLC claims compliance with the Global Investment Performance Standards (GIPS®). Current and qualified po ten tial investors may contact Research Affiliates, LLC at institutional@rallc.com to receive a list of composite descriptions, a GIPS compliant presentation, and general information regarding the firm’s policies for valuing p ort folios, calculating performance, and preparing compliant presentations .

• The material contained in this document is for information purposes only. This material is not intended as an offer or solici tat ion for the purchase or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any transaction. Any offer to sell or a solicitation of an off er to buy or sell shall be made solely to qualified investors through a private placement memorandum for pooled investment vehicles, or investment management agreement for separately mana ged accounts. This information is intended to supplement information contained in the respective disclosure documents. The information contained herein should not be const rue d as financial or investment advice on any subject matter. Research Affiliates, LLC and its related entities do not warrant the accuracy of the information provided herein, eit her expressed or implied, for any particular purpose.

• The index data published herein are simulated, no allowance has been made for trading costs, management fees, or other costs, ar e not indicative of any specific investment, are unmanaged and cannot be invested in directly. Past simulated performance is no guarantee of future performance and actual inv est ment results may differ. Any information and data pertaining to an index contained in this document relate only to the index itself and not to any asset management product bas ed on the index. With the exception of the data on Research Affiliates Fundamental Index, all other information and data are based on information and data from third party sour ces .

• Investors should be aware of the risks associated with data sources and quantitative processes used in our investment managem ent process. Errors may exist in data acquired from third party vendors, the construction of model portfolios, and in coding related to the index and portfolio construction proc ess . While Research Affiliates takes steps to identify data and process errors so as to minimize the potential impact of such errors on index and portfolio performance, we cannot guarantee tha t such errors will not occur.

• The RAFI® US Equity Long/Short Index, RAFI Fundamental U.S. Style Index Series, and Enhanced RAFI Index Series is calculated by S&P Dow Jones Indices LLC or its affiliates. S&P® is registered trademark of Standard & Poor’s Financial Services LLC (“S&P”) and Dow Jones ® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”) and have been licensed for use by S&P Dow Jones Indices LLC and its affiliates. Investment products based on the RAFI® US Equity Long/Short Index is not sponsored, endorsed, sold or promoted by S&P Dow Jones Indices LLC, Dow Jones, S&P or their respective affiliates and none of S&P Dow Jones Indice s L LC, Dow Jones, S&P or their respective affiliates makes any representation regarding the advisability of investing in such product(s).

• S&P Dow Jones Indices LLC, its affiliates, sources and distribution agents, and each of their respective officers, directors, em ployees, agents, representatives and licensors (collectively, the “Index Calculation Agent”) shall not be liable to Research Affiliates, LLC, any customer or any third part y f or any loss or damage, direct, indirect or consequential, arising from (i) any inaccuracy or incompleteness in, or delays, interruptions, errors or omissions in the delivery of the RA FI® US Equity Long/Short Index or any data related thereto (the “Index Data”) or (ii) any decision made or action taken by Research Affiliates, LLC, any customer or third party in reli anc e upon the Index Data. The Index Calculation Agent does not make any warranties, express or implied, to Research Affiliates, LLC, any of its customers or anyone else regarding the I nde x Data, including, without limitation, any warranties with respect to the timeliness, sequence, accuracy, completeness, currentness , merchantability, quality or fitness for a particular purpose or any warranties as to the results to be obtained by Research Affiliates, LLC, any of its customers or other person in connection with the use of the Index Data. The In dex Calculation Agent shall not be liable to Research Affiliates, LLC, its customers or other third parties for loss of business revenues, lost profits or any indirect, consequent ial , special or similar damages whatsoever, whether in contract, tort or otherwise, even if advised of the possibility of such damages .

• Russell Investments is the source and owner of the Russell Index data contained or reflected in this material and copyrights rel ated thereto. Russell Investments and Research Affiliates, LLC have entered into a strategic alliance with respect to the Russell Fundamental Indexes. Subject to Research A ffi liates, LLC’s intellectual property rights in certain content, Russell Investments is the owner of all copyrights related to the Russell Fundamental Indexes. Russell Investments a nd Research Affiliates, LLC jointly own all trademark and service mark rights in and to the Russell Fundamental Indexes. Research Affiliates, LLC is the owner of the trademarks, servi ce marks, patents and copyrights related to the Fundamental Index and the Fundamental Index methodology. The presentation may contain confidential information and unauthoriz ed use, disclosure, copying, dissemination, or redistribution is strictly prohibited. This is a presentation of Research Affiliates, LLC. Russell Investments is not responsib le for the formatting or configuration of this material or for any inaccuracy in Research Affiliates’ presentation thereof.

• The FTSE Research Affiliates Fundamental Indexes are calculated by FTSE International Limited (FTSE”) in conjunction with Re sea rch Affiliates LLC (“RA”). All rights and interests in the FTSE Research Affiliates Fundamental Indexes vest in FTSE. All rights in and to the RA fundamental weighting methodology use d in the calculation of the FTSE Research Affiliates Fundamental Indexes vest in RA. All rights in the FTSE indices and / or FTSE ratings (together the “FTSE Data”) ve st in FTSE and/or its licensors. Except to the extent disallowed by applicable law, neither FTSE nor RA nor their licensors shall be liable (including in negligence) for any loss ari sing out of use of the FTSE Research Affiliates Fundamental Indexes, the FTSE Data or underlying data by any person. “FTSEâ„¢” is a trademark of the London Stock Exchange Plc and is used by FTSE under license. “Research Affiliates” and “Fundamental Index” are trademarks of RA. FTSE is not an investment adviser and makes no representation regar din g the advisability of investing in any security. Inclusion of a security in an index is not a recommendation to buy, sell or hold such security. No further distribution of FT SE Data is permitted without FTSE’s express written consent

• The RAFI® Bonds US Investment Grade Index and RAFI® Bonds US High Yield Index is calculated by ALM Research Solutions, LLC. i n c onjunction with Research Affiliates, LLC. All rights and interests in the RAFI® Bonds US Investment Grade Index and the RAFI® Bonds US High Yield Index vest in Research Af fil iates, LLC. All rights in and to the Research Affiliates, LLC Fundamental Index® concept used in the calculation of the RAFI® Bonds US Investment Grade Index and the RAFI® Bo nds US High Yield Index vest in Research Affiliates, LLC. The RAFI® Bonds US Investment Grade Index and the RAFI® Bonds US High Yield Index are not sponsored, endorse d, sold or promoted by ALM Research Solutions, LLC., and ALM Research Solutions, LLC. makes no representation regarding the advisability of investing in such product(s). Ne ith er ALM Research Solutions, LLC. nor Research Affiliates, LLC make any warranties, express or implied, to any of their customers nor anyone else regarding the accuracy or com pleteness of any data related to the RAFI® Bonds US Investment Grade Index or the RAFI® Bonds US High Yield Index. All information is provided for information purposes only. Nei the r ALM Research Solutions, LLC. nor Research Affiliates, LLC accept any liability for any errors or any loss arising from the use of information in this publication .

• Copyright MSCI. All Rights Reserved. Without prior written permission of MSCI, this information and any other MSCI intellectual property may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used to create any financial instruments or products or any indices. This information is provided o n an “as is” basis, and the user of this information assumes the entire risk of any use made of this information. Neither MSCI nor any third party involved in or related to the computing or compiling of the data makes any express or implied warranties, representations or guarantees concerning the MSCI index – related data, and in no ev ent will MSCI or any third party have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) relating to any use of t his information.

• The trademarks Fundamental Indexâ„¢, RAFIâ„¢, Research Affiliates Equityâ„¢, RAEâ„¢, and the Research Affiliatesâ„¢ trademark and corpo rat e name and all related logos are the exclusive intellectual property of Research Affiliates, LLC and in some cases are registered trademarks in the U.S. and other co untries.

• Various features of the Fundamental Indexâ„¢ methodology, including an accounting data – based non – capitalization data processing sy stem and method for creating and weighting an index of securities, are protected by various patents, and patent – pending intellectual property of Research Affiliates, LLC. (Se e all applicable US Patents, Patent Publications, Patent Pending intellectual property and protected trademarks located at http://www.researchaffiliates.com/Pages/legal.aspx#d, which ar e fully incorporated herein.) Any use of these trademarks, logos, patented or patent pending methodologies without the prior written permission of Research Affiliates, LLC, is expressly prohibited. Research Affiliates, LLC, reserves the right to take any and all necessary action to preserve all of its rights, title, and interest in and to these ma rks , patents or pending patents.

• Neither Research Affiliates, LLC nor its related entities provide investment advice outside of the United States or offer or sel l any securities, commodities or derivative instruments or products. Any such business may only be conducted through registered or licensed entities and individuals permitted to do so wi thin the respective jurisdiction. © Research Affiliates, LLC. All rights reserved. Duplication or dissemination prohibited without prior written permission


?>