When the Federal Open Market Committee meets next week, investors will be looking for clues regarding the Federal Reserve’s policy path in 2019. Will there be one rate hike, or none at all? (We estimate that there will be one, but that it won’t occur at the upcoming meeting. Investors will likely have to wait at least a few more months to earn an extra 25 cents a year on every $100 in their money market funds.)

The bigger story

At Vanguard, we’ll be training our magnifying glass on other clues—namely, the Fed’s inflation outlook and any changes in its projected path for the federal funds rate. Whether short-term rates follow the Fed’s forecast of two more hikes this year, our expectation of one hike, or bond investors’ call of no hikes at all could have implications not only for bond investors, but also for our financial models.

Both interest rates and inflation are inputs in Vanguard’s proprietary “fair-value” cyclically adjusted price/earnings (CAPE) ratio. This tool can help investors assess whether the stock market is under- or overvalued, and thereby establish a reasonable range of expected returns over the next decade. For our clients with investment goals such as paying for college educations and saving for retirement, that longer-term outlook is what counts.

Forecasting stock market returns has proven a perilous pursuit

Our research (and that of others) has demonstrated that many commonly used stock forecasting metrics have a poor track record, even at long investment horizons.

However, valuation indicators—and CAPE ratios in particular—have proven useful in determining whether the market is fairly valued. That doesn’t make these indicators a good market-timing tool, but depressed stock market valuations are typically followed by elevated returns over the subsequent decade, and vice versa.

Let’s look at a few cases using the traditional CAPE ratio, which divides the current price of the Standard & Poor’s 500 Index by the average inflation-adjusted earnings generated by the companies in the index over the previous 10 years. (The decade-long period is used to capture the earnings power of those companies over a business cycle, rather than their earnings for a single year.) The CAPE ratio in 1982 was at less than 7x, compared with its historical average of about 16.6x, suggesting that it was significantly undervalued. In the subsequent decade, the index posted an annualized return of 18.4% per year. And after reaching an all-time high of 44x in 2000, the index returned an annualized –0.9% per year over the “lost decade” for stock returns that followed.

A better yardstick: Vanguard’s fair-value CAPE

The CAPE compares the stock market’s current level against its historical average. But that’s a one-size-fits-all-market-environments approach.

We’ve found that the CAPE ratio has more predictive power if interest rates and inflation levels are factored in. After all, one might expect that today’s low interest rate/low inflation environment would make investors more willing to pay a higher price for future corporate earnings. The result of our approach is a “fair-value” estimate for the stock market that takes into account current economic and market conditions. (You can find our methodology and calculations here: Improving U.S. Stock Return Forecasts: A “Fair-Value” CAPE Approach, published in the Winter 2018 issue of The Journal of Portfolio Management.)

What CAPE ratios are telling us about current valuations

At the beginning of 2018, the traditional CAPE ratio was at a multiyear high—about 33x—surpassed only by the peak that preceded the collapse of the dot-com bubble. A blind reversion to the long-term average of about 16.6x would bode ill for future stock returns. But with interest rates and inflation so low, we aren’t expecting that to happen.

Vanguard’s fair-value CAPE ratio paints a less alarming picture. It suggests that valuations are indeed high, but the difference between the CAPE ratio and our fair-value range does not suggest that valuations are in bubble territory, as it did in the late 1990s.

The CAPE ratio is high, but not alarmingly above our current estimated fair-value range for the S&P 500 Index

Notes: Fair-value CAPE is based on a statistical model that corrects CAPE measures for the level of inflation expectations and for lower interest rates. The statistical model specification is a three-variable vector error correction, including equity earnings yields, ten-year trailing inflation, and ten-year U.S. Treasury yields estimated over the period January 1940–January 2019.

Source: Vanguard calculations, based on data from Robert Shiller’s website (aida.wss.yale.edu/~shiller/data.htm), the U.S. Bureau of Labor Statistics, and the Federal Reserve Board.

So while we’re not expecting another lost decade, the returns of U.S. stocks over the next ten years are likely to be below their historical averages because valuations are currently elevated. The most likely range of outcomes, according to our latest projections, is annualized returns of 4%–6% over the coming decade.

At the conclusion of next week’s Fed meeting, the financial press will be focused on when the next rate hike might come. But we’ll be more interested in the Fed’s assessment of the longer-term outlook for interest rates and inflation. This information will help us arm our clients with a reasonable range of long-term return expectations on which to base their investment decisions.

Note: All investing is subject to risk, including the possible loss of the money you invest.