In the last post we looked at sequencing risk and showed how a bad sequence of Super returns can impact your spend levels in retirement. We presented a number of strategies for mitigating sequencing risks, and showed that the only one of the presented options that was likely to be successful was the strategy of developing a buffer.
It’s not only the impact of a bad sequence of returns that would benefit by the use of a buffer, but mitigating the impact of a prolonged period of poor returns (such as occurred in the 70s) might also benefit by buffering.
A method of forecasting poor market performance in the mid term (or at least the likelihood of poor market performance) would be handy as it would allow us to know if building up such a buffer is likely to be necessary.
In this post we look at an accepted method of forecasting returns in the market over the next 10 or 20 years, which is the length of period we would be most interested in as a retiree or pending retiree.
Price Earnings Ratio
The price earnings ratio for a company is its share price divided by its Earning Per Share. The most common method of working out the Earnings Per Share is to divide the net income from the most recent 12 month period by the weighted average number of shares on issue during this period.
A company which is expected to grow and/or presents low risk will typically have a high P/E ratio and vice-versa. The average US equity P/E ratio between 1900 and 2015 is about 15.
The P/E ratio can be worked out for entire markets by weighting the P/E ratio of component stocks by their market capitalisation. At the time of writing, the US market P/E ratio is 19.3 and the ratio for the Australian Market is 17.8.
Schiller Ratio
Schiller’s ratio, otherwise known as the Cyclically Adjusted Price Earnings ratio (or CAPE) is a variation of the Price Earnings Ratio and is defined as the price divided by the average of 10 years of earnings adjusted for inflation.
The CAPE can be used as an indication of a stock (or market) being overvalued or undervalued by comparing the present P/E ratio with the CAPE (although, on the other hand, a recently elevated P/E ratio might also be indicative of a recent innovation at the company/in the economy). A high market CAPE has also been correlated with low future market returns in the subsequent 10 to 20 year time frame and vice-versa.
The average CAPE for the US S&P composite index in the 20th century was 15.21. The present CAPE for US equity markets is 29.4 and for Australian equities it is 17.8. By historical standards, the US CAPE is very high. More information on international CAPE and PE ratios may be found here.
The diagram below shows the CAPE for the S&P composite index at various times versus subsequent 20 year returns.
You can see that, in general, the higher the CAPE, the lower the expected return over the next 20 years. Given the present US CAPE value, it looks like we are in for a run of poor returns from US markets.
Most Australian funds have international shares in their portfolio. In addition Australian market performance is highly correlated with the performance of US markets. The AustralianSuper balanced option, for example, has, at the time of writing, about 34% international shares and 26% Australian Shares. On this basis, we might expect a high CAPE to impact on the returns of Australian Superannuation funds. We examine this proposition in the next section.
The Schiller Ratio and Australian Super Funds
Pending Australian retirees are likely to be most interested in how the the Schiller ratio relates to real returns from Australian Super funds, because most Australians use Super to fund their retirement.
The diagram below shows the relationship between the S&P 500 Schiller ratio (the average over a year) and the real performance of the AustralianSuper balanced option over the next 10 years and over the next 20 years.
We would expect the CAPE and the returns to mirror each other and we do roughly get this behaviour with the mirror around CAPE =25, Return = 5.00% line.
Scatter diagrams can be a bit more instructive:
You can see from the above, the relationship is fairly clear cut. The least squares best fit line shows returns reducing as CAPE increases, with a reduction in return of 0.16% (0.07%) for every increase in CAPE value for 10 (20) year returns. We can see, however, that even when the CAPE is quite high, we still get reasonable returns albeit lower than the average.
There are also some anomalies and these are shown in the table below:
| Year | CAPE | 10 Year Average Subsequent Returns |
| 1997 | 30.8 | 7.37% |
| 1998 | 35.9 | 5.75% |
| 2007 | 26.7 | 3.63% |
If we use the least squares best fit line to predict the returns from the present (December, 2018), given the present CAPE of about 30, we would expect a real average return of about 5% over the next 10 years and about 5.5% over the next 20 years. This is quite a bit higher than the value we have been using to work out spend levels (2.8%), but also quite a bit lower than the average AustralianSuper balanced option return season since inception (6.7%).
Conclusion
A high US market Schiller ratio is correlated with poor US market returns for the subsequent 20 years. Australian market returns are correlated with US markets.
At present, the Schiller ratio for the US markets is very high. If past correlations are a guide, this would indicate that we are in for a run of poor returns from the US and Australian markets during the next 20 years, a timeframe of interest to pending retirees.
Although most pending retirees will be interested in the likely performance of the markets in the next 10-20 years, they will often be more interested in the likely performance of Australian Superannuation funds over this period.
We have examined the relationship between the Schiller Ratio and Australian Super funds, using the AustralianSuper Balanced option as an example and discovered there is a similar relationship. We have found, however, that even at high CAPE ratios, returns are reasonable and higher than we have used for planning.
These correlations are useful information to pending Australian retirees as it informs the amount of savings that may be required to fund retirement.
Retiring early for Australians 