Bill Gross has taken offhis sunglassesin his latest note to investors (though half of it is a reprinting of his now infamous speech at Morningstar last month), dropping all humorous anecdotes and life lessons in favour of a more straight ahead analysis.
For the past few months, Gross has been expounding on the concept of The New Neutral, his term for the all-time-low interest rate environment facilitated by the world’s central banks that investors now find themselves in.
One of the implications of this may be that all financial assets, not only bonds, may need to be repriced “relative to historical experience,” he writes. In his latest note, Gross takes a look at what we see when we reconfigure Robert Shiller’s 10-year cyclically adjusted price-to-earnings (CAPE), one of the most widely accepted means of valuing stocks.
CAPE, or the cyclically-adjusted price-earnings ratio, is calculated by taking the S&P 500 and dividing it by the average of ten years worth of earnings.
“At PIMCO, we are amazed that little outside analysis has been applied to this concept that to us affects the array of financial assets available to investors,” he says.
The median 10-year CAPE has historically been around 17x price-to-earnings. But the “new neutral” 0% interest rate environment suggests that the figure should be revised upward to 20x, based on another formula, called the Gordon model, that looks at dividends as a function of rates.
That may sound steep, but the current CAPE of 25x shows it could be a whole lot steeper. Gross [emphasis his]:
…the current CAPE of 25x, as shown in Chart 1, is less bubbly than presumed. Fed officials who cite bubbly aspects of “financial conditions” should therefore be less alarmed. If the real New Neutral is significantly lower than 10 or 20 years ago, P/E ratios should be higher, credit spreads should be tighter, and home prices less bubbly than presumed if, in fact, The New Neutral is “neutral” and can lead to historical levels of asset volatility. The New Neutral is critical to future investment success. This currently is PIMCO’s “one big idea.
“The New Neutral is not an explicit Yellen or Draghi Put but it can be a rather comforting pacifier, suggesting that yields, credit spreads and P/E ratios themselves are more rational than many market observers fear,” he wrote.
Here’s the chart:
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