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Commentary

Are the Odds Stacked Against Stock Funds?

Robert Shiller's S&P CAPE valuation data suggests moderate headwinds for large-cap stock funds, and even active funds may feel the drag.

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After the recent market decline, Robert Shiller's cyclically adjusted price/earnings (CAPE) ratio of the S&P 500 Index is now around 20 times, according to the data published on the Yale economist's website. This is well above its historic trading levels, suggesting that investors, especially those in domestic large-cap funds, may need to moderate their return expectations for the stock sleeve of their portfolios.

We did some digging and found that the implications stretch even beyond S&P 500 Index funds. We looked at the 24 large-cap actively managed funds that have more than $10 billion in assets and found that they have tracked the market closely enough to make CAPE a highly useful metric.

What Is CAPE?
CAPE is also called the Graham and Dodd P/E, because of Benjamin Graham's emphasis on normalizing a firm's earnings through a full economic cycle. It is the current price of stocks in the index relative to their 10-year average earnings. It's instructive to look at stocks and the market this way because a long-term average can produce a truer picture of sustainable economic performance than a single point in time.

Taken from Shiller, data in Jason Zweig's edition of Benjamin Graham's The Intelligent Investor shows that from 1898 through 1992, purchasing stocks when the market is trading at 21 times CAPE or higher has led to a subpar average annual return of around 6% over the following decade.

This makes sense. Stocks are units of ownership in and claims to profits of underlying businesses, so the more you pay for shares relative to earnings, the less your chance of achieving robust returns. And since CAPE looks at a 10-year average, it can provide insights into a firm's true earnings power that a one-year number can't, because a one-year earnings number may be an outlier.

What About Actively Managed Funds?
CAPE isn't just for index funds. As mentioned, we examined 24 large-cap actively managed funds with more than $10 billion in assets and found most resembled the index closely enough to warrant investors in them to be cognizant of CAPE.

The table below shows actively-managed large-cap funds with over $10 billion in assets. The first column indicates the common holdings each fund has with the  Vanguard 500 Index Fund (VFINX). In aggregate, the funds had 73% of their holdings in common with the market benchmark. The second column shows a similarity score, which indicates the weight of each fund's overlapping holdings with the index fund. So although the funds average 73% overlap with the index fund in terms of number of holdings, they average 77% overlap in terms of the weights of the holdings they have in common with the index fund.

Finally, we included the R-squared metric, which indicates what percentage of each fund's monthly returns corresponds to the index fund's returns over the past three years. The correspondence is very high, with the funds averaging a 94 R-squared.

  Common Holdings Similarity Score R-Sq Category 10-year Avg. Ann Return* Amer Funds Fundaml Invest 68.2% 72.7% 95 Lg Bl 3.34% Amer Funds Inv. Co. of Amer 77.9% 85.6% 99 Lg Bl 2.46% Davis NY Venture 76.6% 79.9% 97 Lg Bl 1.86% Hartford Cap Appreciation 57.3% 59.6% 90 Lg Bl 3.38% Fairholme 37.8% 61.3% 81 Lg Bl 14.10% Fidelity Disciplined Equity 74.3% 74.7% 95 Lg Bl -0.19% Amer Funds AMCAP 74.7% 81.0% 97 Lg Gr 2.35% Amer Funds Gr Fund of Amer 71.8% 77.9% 94 Lg Gr 1.10% Fidelity Adv New Insights 62.6% 67.2% 89 Lg Gr N/A Fidelity Blue Chip Growth 78.6% 78.8% 95 Lg Gr -2.12% Fidelity Contrafund 64.4% 68.2% 90 Lg Gr 2.98% Fidelity Growth Co 61.4% 61.5% 86 Lg Gr -1.97% Fidelity Magellan 63.2% 64.1% 90 Lg Gr -2.25% T. Rowe Price Bl Chip Gr 92.2% 92.6% 92 Lg Gr -0.57% T. Rowe Price Gr Stock 83.5% 83.4% 89 Lg Gr 0.71% Amer Funds Amer Mutual 83.4% 94.8% 99 Lg Val 4.97% Amer Funds Wash Mutual 94.5% 95.9% 98 Lg Val 3.29% Eaton Vance Lg Cap Val 91.9% 92.8% 96 Lg Val 5.43% MFS Value 89.2% 89.8% 98 Lg Val 5.45% Mutual Shares 32.9% 40.5% 94 Lg Val 5.20% Dodge & Cox Stock 74.4% 75.6% 96 Lg Val 6.31% Fidelity Equity Income 77.4% 80.9% 98 Lg Val 2.69% T. Rowe Price Eq Inc 87.7% 93.0% 96 Lg Val 5.10% T. Rowe Price Value 81.1% 84.8% 96 Lg Val 5.13% Average 73.2% 77.4% 93.8 N/A 2.99% Vanguard 500 Index N/A N/A N/A Lg Bl -0.73%
Through 03-31-10
 

The two outliers are  Fairholme (FAIRX) and  Mutual Shares (TESIX). Their holdings rarely overlap with the index's and Fairholme's R-squared, at 81, is the lowest of the group. At 94, Mutual Shares' R-squared is high, despite its low similarity, because it has 126 holdings. It's hard for a fund that holds this many stocks to behave much differently from the index, even if it doesn't hold the same stocks as the index.

Fairholme, by contrast, has 23 holdings, and tends to hold some cash. Perhaps not coincidentally, Fairholme's 14% average annualized return for the 10-year period through March 31, 2010, smashed those of both the index and its popular large-cap peers. If you're going to beat the index by a significant margin, you have to avoid looking like it.

 

So for nearly all the funds, the cyclically adjusted P/E of the market is important, and right now it doesn't look wildly attractive at 20, which is well above the historic norm of around 16. Some good news is that the large active funds, in aggregate, produced a nearly 3% annualized return for the past decade, which, though anemic in absolute terms, certainly beat the index fund's nearly 1% annualized loss. Weighting Fairholme equally to other funds many times its size, however, produced a rosier picture for active management among behemoth funds than may be justified. 

Also, although we couldn't include the data in the chart, going back 20 years showed that the 18 funds with records that long produced a 9.8% annualized return, in aggregate, versus an 8.6% average annualized return for the Vanguard 500 Index Fund. This shows a weaker victory for active funds over the longer haul, and suggests that large actively managed funds would struggle to overcome an expensive market.

Nothing's Perfect
CAPE has its limits. First, as growth-fund managers would argue, CAPE is an average of past earnings, not an estimate of future ones. Earnings sometimes can improve enough in the future to mitigate the high price paid for past earnings. Also, despite recessions, the economy tends to grow at least a bit from year to year over the longer haul. In fact, over the 94-year period in Zweig's work, investors enjoyed returns of over 9% for the next decade in four of 18 instances when buying stocks at over 19 times cyclically adjusted earnings. But they also produced gains of 5% or less over the next decade--including an annualized loss of 0.10% in one instance--for eight periods when buying in at more than 18 times CAPE. So you could do well paying a premium, but the odds are stacked against you.

Our own research, shown in the chart below, confirms that buying the index in the 20-30 CAPE range from 1957 through 2000 produces returns in the 6% range on average.

Still, another drawback is that CAPE is an average of stocks in one index. On paper, actively managed funds should be able to avoid expensive stocks and snap up cheaper ones poised for more robust returns. The overall market's valuation perhaps shouldn't be decisive for talented active managers.

That's true in theory but not always in practice. As indicated, most funds with more than $10 billion in assets have a hard time distinguishing themselves from the index. So when the entire market is trading at an average of 20 times CAPE, the degree of difficulty goes way up--even for the most talented active managers. It's akin to trawling an overfished bay. When the market as a whole is dirt cheap, by contrast, it's more like shooting fish in a barrel.

Don't Panic
Even though the market is trading at nearly 20 times CAPE, investors shouldn't panic and flee to cash and bonds. Graham said changing allocations and timing the market is difficult, and he was right. As indicated by fund flows and Morningstar's Investor Returns data, those trying to time their allocation often miss the mark, frequently doing the opposite of what they should do. They add money when the market roars, and sell in a panic when it drops.

The current CAPE level is above average but isn't panic-inducing. Your best bet is to hang tough, keeping your prearranged allocation steady. Prepare for single-digit annualized long-term returns (say, 5%-7%) for money invested in stock funds today, and then consider adding more to your stock funds if the market drops and the CAPE retreats meaningfully to more reasonable levels.

Morningstar fund analyst Ryan Leggio contributed to this article.

John Coumarianos does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.