In the depths of the financial crisis this metric told us that the S&P 500 was, at best, ‘fairly valued’. Not undervalued, or significantly undervalued, just fairly valued.
2009 +25.9%
2010 +4.8%
2011 +2.1%
2012 +15.9%
2013 +32.2%
2014 +13.5%
2015 +1.4%
2016 +13.2%
…I hope anyone who uses garbage valuation metrics like this isn’t underweight equities because the CAPE tells them we’re overvalued. It’s been saying that for nearly a decade now. http://www.cfapubs.org/doi/pdf/10.2469/faj.v72.n3.1
I’ve never seen good evidence it’s useful for timing a market. But I fail to understand why we as humans are prone to such extremes. I don’t think any metric works all the time, but we don’t suddenly start claiming price to earnings, price to book, shareholder yield, etc are garbage. I’m increasingly more and more interested in talking to quant investors, since they seem much more process focused and more aware of how to interpret data and ratios. But it is weird what kind of God status CAPE has become
I haven’t said anything about P/E, P/B, shareholder yield. CAPE is garbage. I can say this because I too am process focused and aware of how to interpret data and ratios.
Accounting practices have changed over time, which directly affect the inputs to CAPE. By looking at today’s value, and comparing to long term averages, you’re basically looking at an apple in a bucket full of oranges and saying ‘that’s a bad orange’. CAPE, as it has traditionally been calculated, has no value other than as sales material for those selling fear.
If you want to learn more about this, check out the link I provided. I’d encourage you to read the full thing, it’s less than 10 pages, but see page 7 for the summary. Total return CAPE suggested that the S&P 500 was overvalued by 40% in Jan 2015, whereas the metric using stable accounting practices suggests just 7% overvaluation on a historical basis. (of course, this is still blind to inflation and interest rates, which obviously justify higher valuations than historical averages)
Perhaps it’s better interpreted as a risk measure, which in some sense all value measures are. But the post 2008 period does seem special in that there was an unusual amount government and Fed intervention to keep things cheery, whereas more “normal” CAPE measurements that are used to establish “normal” values occurred in less interventionist times.
When the interventions stop, we could well see a deflation to more normal CAPE values.
I agree that CAPE doesn’t work as a timing tool. I’m not convinced it’s so much worse than any other valuation metric, though. It also presumes that past earnings are a decent estimator of future earnings, which is one of the weaknesses of almost all multiple approaches.
The thing about bubbles is that they last far longer than you can imagine they will and then pop far faster than you think they will. I think it was Keynes who said that (paraphrased). Also, bubble conditions force everyone to look like an idiot. You do get to choose whether to look like an idiot before the pop or after it.
bchad, the issue isn’t with central banks. It’s that reported earnings are fundamentally calculated differently today than it was 30 years ago. We’re literally looking at different calculations over time, but comparing them as if they are identical.
It would be like saying P/B from 1890-1990 has an average of X, and then saying ‘starting in 1990, we’re going to exclude inventory from book value’. And then continuing to use the averages from the prior 100 years to determine whether P/B is above or below average. Of course the number is different, the measurement is different.
*though central banks and all that have certainly changed things, don’t get me wrong. But all that aside, the primary issue is the basic math has changed.
So your issue is with the baseline more than with the idea that one should use long term earnings streams instead of just the past year or estimated next year’s earnings.
So then the question is “does it seem high to you now or does it seem fairly valued?” If you went back and readjusted earnings to be consistent (and I know one can only estimate that most likely), do you think the baseline would be about where the present CAPE sits?
Absolutely, my issue is in how the ratio is built. Accounting standards have changed, which change the input to reported earnings, which change the calculation of CAPE, which make the practice of comparing today vs. the past very distorted. The CAPE in 1980 is fundamentally a different valuation metric than it is in 2016.
Jeremy Siegel talks about these changes in-depth. He also recalculates the formula using operating earnings and NIPA profits, both of which show greater predictive power than reported earnings, and both of which show less overvaluation to historical averages.
Dr. Siegel just spoke at our annual society dinner and spent a lot of his time discussing CAPE and S&P Operating earnings. It was a pretty interesting presentation.
I would love to hear Professor Siegel’s talk and I think the pdf from the OP had some interesting points but I didn’t find the “accounting standards have changed” argument to be particularly compelling. Nearly every change in standard, or outright new standard, only has a timing effect on the Income Statement. And ten years seems like a long enough time for most things to wash out.
I feel awkward commenting in this thread because of bchad for some reason…
The measurement issues of CAPE are certainly something to be mindful of. But it also depends how the error manifests itself. I’m just not so certain it matters much if you are comparing different countries. Seems this error is more important when you are comparing one country over time. Interesting enough, 2016 was a great year for a the CAPE country strategy. The correlations between returns and level was really high. The fund that markets themselves as using the Cape strategy had some fancy PDF showing the results. The problem I’m running into is that some of the countries aren’t easy to invest in. I need to figure out if this subset of the actual universe still benefits from this strategy. Given what seems to be universal nature of value across markets, I assume it does.
You do realize that most countries have different accounting practices right? That saying a CAPE of 20 in Japan is different than a CAPE of 20 in Vietnam? That your comparing the price of something to two different things and using that metric to make decisions? Said another way…if Japan has a CAPE of 20 and Vietnam has a CAPE of 19.5…which is more attractively priced?
Yep, perfectly aware. But even without adjusting for that, it still seems to work as a naive strategy. I’m not a fan of doing things that don’t seem to have an economic explanation. Still doing the required reading on this strategy of course, but one adjustment some make is investing in which are relatively cheap to their history. So even if Russia continually has a CAPE half of the United States, Russia is only bought when its percentile rank relative to its history is attractive vs other countries.
At the end of the day, I am trying to find the lowest cost way to get international value in a rules based method.
CAPE is obviously a relative measure and if you are a proponent of mean reversion then yes US equity markets are currently pretty overvalued. Does that mean they will revert back to the mean tomorrow, a week, a month, years from now? maybe or maybe not. This is the issue I have with P/E in general. The denominator is open for MANY different interpretations and assumptions. Now, what I would be very interested to see is the intrinsic valuations of all of the firms in the S & P 500 with widely accepted assumptions regarding terminal values, discount rates, growth rates and appropriate adjustments to cash flows. Then comparing that to where we currently are.
If earnings seem fine for these companies, I will always question things such as Non-GAAP vs GAAP, high quality vs. low quality earnings/reporting and go from there.
Here’s a somewhat similar index for those who are interested in these things:
https://www.gurufocus.com/stock-market-valuations.php
I think the big item that these sort of long-term metrics lack is they don’t factor in interest rates. When interest rates are at historically low levels, higher stock prices can be justified. Of course if you believe that interest rates will ultimately return to their long run average then you would be very bearish on the market today.