Morningstar Magazine - October/November 2017 - 50

Strategies

total yields follow a stationary time-series process,
while dividend yields experienced a structural
break in the early 1980s. Total payouts are
thus a more stable measure of corporate payouts
than dividends.

CAPE vs. CATY

We now turn to evaluating the merits
of CATY compared with CAPE as a long-run
valuation measure.
To recap, the CAPE is calculated by dividing the
stock's current price by its 10-year real
earnings-per-share average, while CATY is
calculated by dividing the 10-year average of real
total payouts by the price. Both measures are
based on a ratio of fundamentals (over 10 years, or
cyclically-adjusted), and the current price.

Buybacks have a fundamentally different impact
on the return-generation process than dividends
have. While a payout via dividend increases
the income return, buybacks increase the price
return (per-share) as a buy-and-hold investor's
share in a company is increased.

EXHIBIT 2

Consistent Yield Total yield, which includes both dividends and buybacks, generally
reverts around its long-term mean.
1871-2016

Total Yield
15
%
12
9
4.48 6
3

Total yield is the dividend yield plus the
buyback yield depicted in Exhibit 1.

1890

1871

1910

0
-3
1930

1950

1970

1990

2010

Overall, these measures have tracked the relative
valuation of the U.S. stock market similarly
over time. EXHIB IT 3 shows the level of under- or
overvaluation of each measure relative to
its own history. Between 1891 and 2017, the two
valuation measures had a 91% correlation.
Yet, there were several periods of divergence:
For instance, during the 1950s and 1960s, earnings
grew faster than dividends in the post-World
War II era as companies retained a greater fraction
of earnings, leading CATY to point to a higher
level of overvaluation than CAPE. CAPE and CATY
fell back in sync during the 1990s through the
time of the global financial crisis, but have
diverged again since. Through June 30, the CAPE
was 79% above its long-run average, while CATY
was just 42% over-both measures point to
an overvalued market, but CATY to a lesser extent.
To test which measure has worked better as a
predictor of stock returns, we first inverted CAPE so
that both measures compared (cyclically-adjusted)
fundamentals to current prices. Then, we
ran a return regression of historical valuations on
five-year-ahead real returns using annual data.
Next, we looked at the full period, back to 1881
(EXHIB IT 4 ) and found that CAPE and CATY
had similar prediction power (each had an
R-squared of 18%). This means that both measures
explained close to one fifth of the variability of
future five-year returns.

Source: Morningstar.

EXHIBIT 3

In Sync (Mostly) CAPE and CATY have a high correlation, but at times they diverge.
1871-2016: Over-/Undervaluation vs. Historical Average

CAPE

CATY
200
%
150
79

100

49 50
0
-50
-100
1871

1890

1910

Source: Morningstar.

50

Morningstar October/November 2017

1930

1950

1970

1990

2010

Then we looked at the more recent history since
1970, which is of interest to us because this
includes the period over which researchers have
raised concerns (EXHIB IT 5 ). We found CATY
significantly outperformed, explaining 24% of the
variability of forward returns, while the CAPE
ratio only explained 9%, a striking difference. Our
finding that CATY performed better than CAPE
since 1970 corroborates the evidence provided
by Siegel (2016) that reported earnings may
have underdone structural change in recent
decades, weakening the predictive power of CAPE.
A Viable Alternative

Overall, we demonstrate that CATY is a viable
alternative to CAPE as a long-run valuation
measure. CATY is at least as predictive as CAPE
over the extended history since 1881, but



Table of Contents for the Digital Edition of Morningstar Magazine - October/November 2017

Contents
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