FEDweek

The TSP C Fund and the S&P: how much risk is in the market?

Bull and Bear - TSP C Fund fedweek.com

The C Fund follows the S&P 500, which is up, but is it overpriced? There are several different ways to determine how cheap or expensive the aggregate stock market is.  This article will take a quick look at the numbers for indices like the S&P and the C Fund, because they can shed some light on the current level of risk in the market.

Whether stocks are cheap or expensive depends partly on the definition that’s used.  Over the long run, well-known indices like the Dow Jones Industrial Average and the S&P 500 keep going up and up, partly due to the constant push of inflation, and partly because of increased national economic development.  But the price of an index is not of much use by itself; it needs to be compared to a tangible form of value to be meaningful and useful.

For that reason, the price-to-earnings ratio of the market is a popular indicator.  This ratio divides the price of a stock by its earnings per share, or more broadly can be applied to an entire index where the total index price is divided by the total annual earnings of those companies.

The most well-known version of this is the cyclically-adjusted price-to-earnings (CAPE) ratio.  It’s also called the “Shiller PE” due to having been defined by Nobel laureate Robert Shiller, an economics professor at Yale.  This ratio works by dividing the current aggregate price of stocks by their average inflation-adjusted earnings over the last ten years.

Here’s how the chart looks right now, updated as of March 2017:

Source: Custom chart, using data freely available from Shiller’s Yale website

Currently, with a CAPE ratio of over 29, we’re at the third highest we’ve ever been in terms of market expense.  Only briefly in 1929 and during 1997-2002 has it been higher.

This is relevant because Robert Shiller has evidenced, and other researchers have confirmed, that the CAPE ratio of a market is almost always inversely correlated to its long-term performance over the next ten or twenty years.   The higher the current CAPE ratio is, the worse off stock performance tends to be in the future.  This is because when the price-to-earnings ratio becomes unusually high, either the price has to eventually come down or earnings have to catch up to restore the ratio to a more sensible number.

The ratio can’t tell us almost anything about the short-term, like whether stocks will go up or down this year or next year.  But it can give us a historically strong indicator of whether market returns will be good over the next decade or not.   And currently what it’s telling us is that long-term equity returns won’t be great.

But knowledge is power, and if the evidence indicates that equity returns won’t be stellar going forward, one answer is to try to push your savings rate higher to compensate.  When you’re planning your finances or retirement, it pays to play it safe with your assumed rate of return calculations and save accordingly.

Another possible answer is to diversify your investments.  The TSP is a fantastic investment vehicle, but during certain phases of the market cycle (including perhaps right now), real estate or other investments may give better rates of return.

What about the I Fund?

The C Fund is currently expensive, and the same can be said for the S Fund.  But what about other countries?

As I discussed in a previous article about the problems with the I Fund, the bulk of that index is made up of just five countries: Japan, the UK, Germany, France, and Switzerland.

According to Star Capital, Japan’s market has a CAPE ratio of about 25, while the UK has a CAPE of only 15.  Germany, France, and Switzerland come in at about 19, 18, and 22 respectively.   This data is recent as of the fourth quarter of 2016.  The weighted average CAPE ratio of the I Fund is therefore in the low 20’s.  It’s rather highly priced, but not quite to the extent of the US market.

The US stock market currently is the third most expensive in the world as measured by price-to-earnings, but it’s also one of the most diverse and advanced markets in the world with a greater share of high technology and healthcare stocks that usually command higher price premiums than stocks of other industries.

Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.