Shiller's CAPE - Is There A Better Measure?
Yesterday, I discussed at length whether Dr. Robert Shiller's 10-year cyclically adjusted price-earnings ratio was indeed just "B.S." As I stated repeatedly in that missive:
"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.
Valuation models are not, and were never meant to be, 'market timing indicators.'"
However, there are some very good current arguments against a long term smoothed price/earnings model that warrant some consideration.
- Beginning in 2009, FASB Rule 157 was "temporarily" repealed in order to allow banks to "value" illiquid assets, such as real estate or mortgage-backed securities, at levels they felt were more appropriate rather than on the last actual "sale price" of a similar asset. This was done to keep banks solvent at the time as they were being forced to write down billions of dollars in assets on their books. This boosted banks profitability and made earnings appear higher than they may have been otherwise. The 'repeal" of Rule 157 is still in effect today, and the subsequent "mark-to-myth" accounting rule is still inflating earnings.
- The heavy use of off-balance sheet vehicles to suppress corporate debt and leverage levels and boost earnings is also a relatively new distortion.
- Extensive cost-cutting, productivity enhancements, off-shoring of labor, etc. are all being heavily employed to boost earnings in a relatively weak revenue growth environment. I recently addressed this issue specifically:
"What has also been stunning is the surge in corporate profitability despite a lack of revenue growth. Since 2009, the reported earnings per share of corporations has increased by a total of 230%. This is the sharpest post-recession rise in reported EPS in history. However, that sharp increase in earnings did not come from revenue which is reported at the top line of the income statement. Revenue from sales of goods and services has only increased by a marginal 26% during the same period. This is shown in the chart below."
- The use of share buybacks improves underlying earnings per share which also distorts long term valuation metrics.
FactSet just recently reported that quarterly stock buybacks increased 50% year-over-year in Q1 of 2014. This was the third largest quarterly advance since 2005 with Technology and Industrials surpassing peak buyback spending.
- The extensive interventions by Central Banks globally are also contributing to the distortion of markets.
Due to these extensive changes to the financial markets since the turn of the century, I do not completely disagree with the argument that using a 10-year average to smooth earnings volatility may be too long.
Think about it this way. When constructing a portfolio that contains fixed income one of the most important risks to consider is a "duration mismatch." In other words, an individual buys a 20-year bond but needs the money in 10-years. Since the purpose of owning a bond was capital preservation and income, the duration mismatch leads to a potential loss of capital if interest rates have risen at the time the bond is sold 10-years prior to maturity.
One could reasonably argue that due to the "speed of movement" in the financial markets today, a shortening of business cycles, and increased liquidity that there is a "duration mismatch" between Shiller's 10-year CAPE and the financial markets today.
The first chart below shows the annual P/E ratio versus the inflation adjusted (real) S&P 500 index.
Importantly, you will notice that during secular bear market periods (red shaded areas) the overall trend of P/E ratios is declining. This "valuation compression" is a function of the overall business cycle as "overvaluation" levels are "mean reverted" over time. You will also notice that market prices are generally "sideways" trending during these periods with increased volatility.
You can also see the vastly increased valuation swings since the turn of the century. This is one of the primary arguments against Dr. Shiller's 10-Year CAPE ratio.
Introducing The CAPE-5 Ratio
The need to smooth earnings volatility is necessary to get a better understanding of what the underlying trend of valuations actually is. For investor's periods of "valuation expansion" are where the bulk of the gains in the financial markets have been made over the last 114 years. History shows, that during periods of "valuation compression" returns are much more muted and volatile.
Therefore, in order to compensate for the potential "duration mismatch" of a faster moving market environment, I recalculated the CAPE ratio using a 5-year average as shown in the chart below.
There is a high correlation between the movements of the CAPE-5 and the S&P 500 index. However, you will notice that prior to 1950 the movements of valuations were more coincident with the overall index as price movement was a primary driver of the valuation metric. As earnings growth began to advance much more quickly post-1950, price movement became less of a dominating factor. Therefore, you can see that the CAPE-5 ratio began to lead overall price changes.
As I stated in yesterday's missive, a key "warning" for investors, since 1950, has been a decline in the CAPE-5 ratio which has tended to lead price declines in the overall market. While it is still very early, the CAPE-5 Ratio has declined from 26.25 in November of 2013 to 24.69 currently. The last time that the CAPE-5 ratio started a similar decline was in February of 2011. Of course, that summer experienced a near 20% decline in the markets.
To get a better understanding of where valuations are currently relative to past history, we can look at the deviation between current valuation levels and the long term average. The importance of deviation is crucial to understand. In order for there to be an "average," valuations had to be both above and below that "average" over history. These "averages" provide a gravitational pull on valuations over time which is why the further the deviation is away from the "average," the greater the eventual "mean reversion" will be.
The first chart below is the percentage deviation of the CAPE-5 ratio from its long-term average going back to 1881.
Currently, the 56.23% deviation above the long-term CAPE-5 average of 15.80x earnings puts valuations at levels only witnessed five (5) other times in history. While it is hoped "this time will be different," which were the same words uttered during each of the five previous periods, you can clearly see that the eventual results were much less optimal.
However, as I stated above, the changes that have occurred Post-WWII in terms of economic prosperity, changes in operational capacity and productivity warrant a look at just the period from 1944-present.
Again, as with the long-term view above, the current deviation is 42.75% above the Post-WWII CAPE-5 average of 17.30x earnings. Such a level of deviation has only been witnessed twice previously over the last 70 years in 1996 and 2005. Again, as with the long-term view above, the resulting "reversion" was not kind to investors.
Is this a better measure than Shiller's CAPE-10 ratio? Maybe, as it adjusts more quickly to a faster moving market place. However, I want to reiterate that neither the Shiller's CAPE-10 ratio or the modified CAPE-5 ratio were ever meant to be "market timing" indicators. The purpose is to denote periods where carrying exceptionally high levels of investment risk have provided exceptionally poor levels of future returns. What both of these measures are clearly warning is that future market returns are going to be substantially lower than they have been over the past five years. Therefore, if you are expecting the markets to crank out 10% annualized returns over the next 10 years for you to meet your retirement goals, it is likely that you are going to be very disappointed.