American Consequences - December 2020

There has been much puzzlement that the world’s stock markets haven’t collapsed in the face of the COVID-19 pandemic, and especially in the United States, which has recently been setting record highs for new cases. But maybe it isn’t such a puzzle. A measure we call the Excess CAPE Yield (“ECY”) puts the long-term outlook for the world’s stock markets in better perspective. MAKING SENSE OF SKY-HIGH STOCK PRICES

money out of stocks and putting it into safer alternatives such as bonds, or even under the mattress at home? The cyclically adjusted price-to-earnings (CAPE) ratio, which captures the ratio of the real (inflation-adjusted) share price to the ten- year average of real earnings per share, appears to forecast real long-term stock-market returns well in five influential world regions. When the CAPE ratio is high, long-term returns tend to be low over the next 10 years, and vice versa. Since the COVID-19 shock, CAPE ratios have mostly recovered to their pre-pandemic levels. For example, the U.S. CAPE ratio in November 2020 was 33, exceeding its

Indisputably, asset markets are substantially driven by psychology and narratives. As the Nobel laureate Daniel Kahneman wrote, “familiarity breeds liking,” and several familiar narratives have emerged in the world’s stock markets this year, following the initial COVID-19 shock in the first quarter. For example, there is the V-shaped recovery narrative and the FOMO (fear of missing out) narrative... both might be helping to drive markets to new highs. There is also the work-from-home narrative, which has specifically benefited technology and communication stocks. But are these narratives the only reason why all of us have not considered just pulling our


December 2020

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