OMG! The “Cyclicly Adjusted” PE (CAPE) is over 27!
This is really bad news. At least, that’s what the CNBC headline above would imply. Before you decide it might be a good idea to look into just what exactly CAPE is.
CAPE, simply put, a …
This concept was cooked up back in 1988 by professors John Y. Campbell and Robert Shiller. It eventually won them a Nobel Prize in 1993 and the so-called elevated level of this CAPE PE is often given as a reason by the bears to avoid the market. This is not new. The unfavorable CAPE ratio has been cited as a negative since the very lows of 2009. If you look at the reconstructed history of this metric dating back to 1981, you would find the market really never looked buyable (see below).
A key flaw
“Siegel is not the only savant to question whether this metric should be viewed with the reverence some treat it, but he cited some powerful evidence why it can be misleading. Between 1981 and 2015, the CAPE ratio signaled that equities were overvalued in no fewer than 416 of 422 months (“Jeremy Siegel: Shiller P/E ratio’s fatal flaw, the bullish case”).
One of the key flaws in the Shiller P/E was no fault of Shiller. In 1990, Standard & Poor’s, following the Financial Accounting Standards Board, changed the definition of GAAP (generally accepted accounting principles) earnings to require mark-to-market accounting.
But the change in criteria only required that companies mark down their assets when they have a loss. When an asset increased in value, it could only be marked up when it was sold. “That’s not Bob’s fault,” Siegel said.”
I am not an academic, but …
I question why the Shiller methodology adjusts out the effects of inflation from the earnings calculation. After all, when companies are able to raise prices a portion of those additional revenues will flow to profits and the ability to raise dividends. And, as pointed out above, inflation works to increase the value of corporate assets priced in dollars (something not compensated for in the CAPE PE calculation). Inflation protection is a key reason you would be a long-term holder of common stocks. Importantly, over the past 15 years the disinflationary impacts of globalization and automation have kept a lid on wage growth and pricing. Were this ever to reverse it would be a tremendous tailwind for equities. And this may be one of the reasons for the lift-off we’ve seen in the market, as proposals to spend on infrastructure while cutting taxes and repatriating earnings might be viewed as an inflation igniters
So, what’s with our shocking and negative headline?
First let me say that we have had a stunning (and surprising, based on my initial read “..Black Swan”) rise in equity prices since the election. I was fairly well committed to the market election day (I have been a bull). I have taken a few chips off the table over the past two weeks, but am still very much invested. Reeling in some profits and reserves makes some sense, but our headline, courtesy of CNBC, appears to be typical of the hype and fear generation that is their forte.
Let’s just consider the fundamentals at those particular tops vs. our market today.
- 1929 — this was a euphoric, speculative market top. Back in the day you could buy stocks on 10% margin (a dollar would get you ten dollars worth of stock) and shoe-shine boys on Wall Street were offering stock tips. Leverage was a huge issue. We are not there today.
- 2000– The tech bubble, speculative euphoria was the culprit. The Shiller PE peaked at 44 in December 1999. The actual peak in the S&P 500 PE came in March of 2000 at 28. At that time the 10-year US Treasury note was yielding over 6%. The current PE on the S&P is 24.87 based on reported earnings and 18.45 based on estimated earnings with the 10-year US Treasury note yielding 2.43%. Since 2000 S&P earnings have nearly doubled and the dividend has nearly tripled. And, in those ensuing 16 years, the index is up 45% (less than 3% per year). Finally, since the beginning of this current bull (March 2009), the market has been totally disrespected and unloved. We are making new all-time highs and nobody believes or cares. There is no EUPHORIA a la 1929 or 2000. At those tops everybody loved stocks.
- Finally, in 2008 the housing bubble had just popped and most of us did not see it coming or have a clue as to how insidious and all-encompassing the death spiral it would put us into would be. Nowadays, every one is looking over their shoulders for the next disaster. Importantly, calamities like 2008 are few and far between. Also, that old adage about how you “never see the bullet that kills you”, is a truism in the market. The housing bubble, like 1929, was about debt with a new wrinkle, derivatives. According to some the 2008 housing bubble may be re-inflating and subprime auto lending maybe entering bubble stage. In the event these happen to actually occur, unlike seven years ago, we have shorn up our banking system significantly, and consumer and corporate balance sheets are vastly improved vs. 2008. Do not get me wrong. Another bust a la 1929 and 2008 will occur. It is the way of the world. I just do not see it right now.
Some fine points about the run-up to the 2000 bust
The Shiller PE eclipsed the magic 27 number in 1997, peaking at 44 in December of 1999. The S&P 500 moved from 955 to 1452 during that period ( up 52% in two years). During that entire time the Shiller PE was rating the market highly over-valued. Not very useful, eh? So, why is this even a story on CNBC? They like to scare people to keep them engaged. It has nothing to do with perspective. It has nothing to do with making you a better investor. It is useless information. As the market progresses higher you will see a lot more of this type of commentary–i.e. stay away, danger ahead. It is what they do!
Again, no harm in taking a few chips off the table, but I don’t think we’ve seen the end of this bull. This market has been so unloved and feared (people looking over their shoulders for the next disaster) there is still a tremendous amount of cash on the sidelines. For many the new green light on unfettered capitalism that is emanating from the incoming administration appears to be signaling it is okay to re-enter the water.
What do you think?
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