Shiller's CAPE - Is It Really Just B.S.
In late stage bull market cycles, the inevitable bashing of long term valuation metrics comes to full fruition. In the late 90's if you were buying shares of Berkshire Hathaway stock it was mocked as "driving Dad's old Pontiac." In 2007, valuation metrics were being dismissed because the markets were flush with liquidity and interest rates were low. Today, we once again see repeated arguments as to why "this time is different."
There has been an ongoing debate about Dr. Robert Shiller's Cyclically Adjusted Price Earnings (CAPE) ratio and its current validity. Critics argue that the earnings component of CAPE is just too low, changes to accounting rules have suppressed earnings, and the financial crisis changed everything. The latest was by Wade Slome:
"If something sounds like BS, looks like BS, and smells like BS, there’s a good chance you’re probably eyeball-deep in BS. In the investment world, I encounter a lot of very intelligent analysis, but at the same time I also continually step into piles of investment BS. One of those piles of BS I repeatedly step into is the CAPE ratio (Cyclically Adjusted Price-to-Earnings) created by Robert Shiller."
Let's break down Wade's arguments against Dr. Shiller's CAPE P/E individually.
Shiller's Ratio Is Useless?
"The short answer…not very. For example, if investors followed the implicit recommendation of the CAPE for the periods when Shiller’s model showed stocks as expensive they would have missed a more than quintupling (+469% ex-dividends) in the S&P 500 index. Over a shorter timeframe (2009 – 2014) the S&P 500 is up +114% ex-dividends (+190% since March 2009)."
Wade's analysis is correct. However, the problem is that valuation models are not, and were never meant to be, "market timing indicators." The vast majority of analysts assume that if a measure of valuation (P/E, P/S, P/B, etc.) reaches some specific level it means that:
- The market is about to crash, and;
- Investors should be in 100% cash.
This is incorrect. Valuation measures are simply just that - a measure of current valuation. If you "overpay" for something today, the future net return will be lower than if you had paid a discount for it. Think about housing prices for a moment as shown in the chart below.
There are two things to take away from the chart above in relation to valuation models. The first is that if a home was purchased at any time (and not sold) when the average 12-month price was above the long term linear trend, the forward annualized returns were significantly worse than if the home was purchased below that trend. Secondly, if a home was purchased near the peak in valuations, forward returns are likely to be extremely low, if not negative, for a very long time.
This is the same with the financial markets. When investors "pay" too much for an investment, future returns will suffer. "Buy cheap and sell dear" is not just some Wall Street slogan printed on a coffee mug, but a reality of virtually all of the great investors in our time in some form or another.
Cliff Asness discussed this issue in particular stating:
"Ten-year forward average returns fall nearly monotonically as starting Shiller P/E’s increase. Also, as starting Shiller P/E’s go up, worst cases get worse and best cases get weaker.
If today’s Shiller P/E is 22.2, and your long-term plan calls for a 10% nominal (or with today’s inflation about 7-8% real) return on the stock market, you are basically rooting for the absolute best case in history to play out again, and rooting for something drastically above the average case from these valuations."
"It [Shiller's CAPE] has very limited use for market timing (certainly on its own) and there is still great variability around its predictions over even decades. But, if you don’t lower your expectations when Shiller P/E’s are high without a good reason — and in my view the critics have not provided a good reason this time around — I think you are making a mistake."
While, Wade is correct that investors who got out of the market using Shiller's P/E ratio would have missed the run in the markets from 2009 to present, those same individuals most likely sold at the bottom of the market in 2008 and only recently began to return as shown by net equity inflows below. In other words, they missed the "run" anyway. As I discussed yesterday, investor psychology has more to do with long term investment outcomes than just about anything else.
Peaches for $.25 Post-Bubble?
Wade's second argument is also important which discusses the price of peaches falling to $.25 per pound where he concludes:
"This complete neglect of current market prices in the calculation of CAPE makes absolutely no sense, but this same dynamic of ignoring current pricing reality is happening today in the stock market. Effectively what’s occurring is the higher P/E ratios experienced over the last 10 years are distorting the Shiller CAPE ratio, thereby masking the true current value of stocks. In other words the current CAPE of 26x vastly exaggerates the pricey-ness of the actual S&P 500 P/E ratio of 16x for 2014 and 14x for 2015."
Let's break that statement down into its two basic arguments: 1) Higher P/E ratios over the last 10 years are distorting CAPE, and: 2) the problem with forward P/E ratios.
First, it is true that P/E's have been higher over the last decade due to the aberration in prices versus earnings leading up to the 2000 peak. However, as shown in the chart below, the "reversion" process of that excessive overvaluation is still underway.
Clff Asness directly addressed this concern:
"Some outright hucksters still use the trick of comparing current P/E’s based on 'forecast' 'operating' earnings with historical average P/E’s based on total trailing earnings. In addition, some critics say you can’t compare today to the past because accounting standards have changed, and the long-term past contains things like World Wars and Depressions. While I don’t buy it, this argument applies equally to the one-year P/E which many are still somehow willing to use. Also it’s ironic that the chief argument of the critics, their big gun that I address exhaustively above [from the earlier post], is that the last 10 years are just too disastrous to be meaningful (recall they are actually mildly above average)."
Secondly, I specifically addressed this issue of forward P/E's recently in "The Problem With Forward P/E's:"
"As a reminder, it is important to remember that when discussing valuations, particularly regarding historic over/under valuation, it is ALWAYS based on trailing REPORTED earnings. This is what is actually sitting on the bottom line of corporate income statements versus operating earnings, which is "what I would have earned if XYZ hadn't happened."
Beginning in the late 90's, as the Wall Street casino opened its doors to the mass retail public, use of forward operating earning estimates to justify extremely overvalued markets came into vogue. However, the problem with forward operating earning estimates is that they are historically wrong by an average of 33%."
The consistent error rate in forward earnings projections makes using such data dangerous when making long term investments. This is why trailing reported earnings is the only "honest" way to approach valuing financial markets. Importantly, long term investors should be abundantly aware of what the future expected returns will be when buying into overvalued markets. Bill Hester recently wrote a very good note in this regard in response to critics of Shiller's CAPE ratio and future annualized returns:
"More recently the ratio has undergone an attack from some widely-followed analysts, questioning its validity and offering up attempts to adjust the ratio. This may be a reaction to its new-found notoriety, but more likely it’s because the CAPE is suggesting that US stocks are significantly overvalued. All of the adjustments analysts have made so far imply that stocks are less overvalued than the traditional CAPE would suggest."
We feel no particular obligation defend the CAPE ratio. It has a strong long-term relationship to subsequent 10-year market returns. And it’s only one of numerous valuation indicators that we use in our work – many which are considerably more reliable. All of these valuation indicators – particularly when record-high profit margins are accounted for – are sending the same message: The market is steeply overvalued, leaving investors with the prospect of low, single-digit long-term expected returns. But we decided to come to the aid of the CAPE ratio in this case because a few errors have slipped into the debate, and it’s important for investors who have previously relied on this ratio to understand these errors so they can judge the valuation metric fairly. Importantly, the primary error that is being made is not even the fault of those making the arguments against the CAPE ratio. The fault lies at the feet of a misleading data series."
As clearly stated thoughout this missive, fundamental valuation metrics are not, and were never meant to be, market timing indicators. This was a point made by Dr. Robert Shiller himself in an interview with Henry Blodgett:
"John Campbell, who’s now a professor at Harvard, and I presented our findings first to the Federal Reserve Board in 1996, and we had a regression, showing how the P/E ratio predicts returns. And we had scatter diagrams, showing 10-year subsequent returns against the CAPE, what we call the cyclically adjusted price earnings ratio. And that had a pretty good fit. So I think the bottom line that we were giving – and maybe we didn’t stress or emphasize it enough – was that it’s continual. It’s not a timing mechanism, it doesn’t tell you – and I had the same mistake in my mind, to some extent — wait until it goes all the way down to a P/E of 7, or something."
Currently, there is clear evidence that future expectations should be significantly lower than the long term historical averages. Does the current valuation levels mean that you should be all in cash? No. However, it does suggest that a more cautious stance to equity allocations and increased risk management will likely offset much of the next "reversion" when it occurs.
While I disagree with Wade's assessment, it does not mean that I do not value his opinion. My job is to protect investment capital from major market reversions and meet investment returns anchored to retirement planning projections. Not paying attention to rising investment risks, or adjusting for lower expected future returns, are detrimental to both of those objectives.
Tomorrow, I will introduce a modified version of the Shiller CAPE ratio that is currently flashing a very important warning sign that you should be paying attention too.