A few weeks ago, Yale Professor Robert Shiller won the Nobel prize for his work on irrationality and inefficiency of markets. Since then, we have been treated to a plethora of stories on some of his other work — especially so-called CAPE, Shiller’s measure of long term valuation. The general consensus seems to be that CAPE — the cyclically adjusted price-to-earnings ratio – is elevated, stocks are overvalued, and a crash is imminent.

This is a misreading of both valuation measures, as well as causes of crashes.

CAPE looks at the prior 10 years of trailing earnings. It smooths out any given quarters’ ups and downs, and theoretically includes a full business cycle. The way Shiller intended it to be used was to create a valuation metric that would suggest whether stocks are likely to outperform their average returns over the next 10 years.

Shiller’s CAPE does this well. As Mebane Faber of Cambria Investment Management observed, when CAPE measures are under 10, forward 10-year returns are outstanding. Over the long run, returns fall the higher CAPE rises. However, over the short run, it is anyone’s guess. The range of returns when CAPE is elevated is fairly broad. Indeed, CAPE has been over 20 for the past few years, and U.S equity returns have been strong.
Source: Mebane Faber


The problem we run into is that valuation is not a timing tool. A momentum trader will tell you from personal experience that overpriced stocks can and do get more expensive. Value investors will tell you from their personal experience that cheap stocks can get a whole lot cheaper.

Mean reversion does not occur immediately after an asset moves away from its long-term trend. Any bond trader can tell you that from their personal experience of the past 30 years.


Originally published here

Category: Investing, Trading, Valuation

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15 Responses to “A Few Words About Valuation”

  1. icantdance says:

    Could we deviate from historicals and have sustained historically high CAPE due to central banks?

  2. Alex says:

    In my opinion, if one ever evaluates data and pops off a binary decision (good / bad, safe / crash!), that person is almost certainly off the road, analysis-wize.

    I would add that this data is for the S&P 500 index. I would therefore imagine than any attempt to apply this work to predict returns on other equity markets in other countries, perhaps even other equities in the U.S. (small caps?) would be difficult to support. Not saying they don’t correlate to some extent, but I would not be in a hurry to say that the DAX is relatively expensive because of the current status of the S&P 500 CAPE. Not sure it exists, but CAPE data on other markets would be interesting to compare and evaluate.

    Maybe what this CAPE data is telling us is that if we wish to invest in large-caps, we should cast about elsewhere in the world for relative bargains at this time?

  3. spencer says:

    Remember, Shiller is using 10 year trailing EPS that still includes the 2008 earnings collapse that was a multiple of the normal cyclical drop.

    When this rolls out of the data his PE will fall significantly.

    It,is not that his data is bad, but you do need to understand what you are looking at.

    • We ran that today

      Back out 2008-09 and Shiller CAPE falls from 24 to 21.5

    • b_thunder says:

      Shiller’s calculations also include bank earnings greatly inflated by the 2003-2007 credit bubble, 2003 -2007 commodities bubble, and all sorts of illegal activities (LIBOR, FX, JPM whale trades, Jefferson County scam, etc) which are unlikely to be repeated in such a brazen way as in the prior 10 years.
      2008/09 earning collapse is canceling out some of the excess earnings that are unlikely will be repeated

    • rd says:

      The primary reason that the 10 year period is used to calculate CAPE is to get the earnings over one or more full business cycles. It isn’t hard to game earnings for a year or two, but it is hard to game them for a decade as Enron, the banks, and many others have found out over the years.

      A primary reason that the bank earnings collapsed is because they were built on fraudulent sand that washed away when the housing tide went out. If you averaged the earnings from 2003-2009, they look kind of normal – you would never know that a lot of excitement and dismay occurred over that period.

      Grantham makes 7 year forecasts, instead of 10 but the concept is similar. The short-term predictability for earnings, stock market prices etc has a large random component, but much of the randomness goes away when longer periods are looked at.

  4. rd says:

    It is hard to figure out exactly what CAPE, Q etc. mean today as we are in a unique period. This is the first time that I can think of when the US central bank coordinates with other central banks with a stated goal of pushing asset prices and keeping them up. This is the opposite of the early 80s when Volcker explicitly stated that he wanted to kill inflation and asset prices were part of that process. There weren’t particularly useful economic and monetary theories in place for use by central bankers before the 1930s, so those market cycles have undergone lots of scrutiny to try to figure out what went wrong and how not to repeat them.

    Bernanke’s efforts mean that cash and bonds have yields that are significantly below their normal spreads from inflation. That has been intentional with the stated goal of forcing people to buy stocks and other risky assets if they want to keep pace with inflation.

    With the exception of 1929 to 1932, it has generally taken 13 to 20 years for a full secular bear to play out from peak CAPE to single digit CAPE as all of the defences need to be exhausted over time. 2008-2009 was headed towards doing that in 9 years before Bernanke and Paulsen stepped in to stop the free-fall towards a 1932-type bottom. The question is whether or not Bernanke’s continued actions will prevent the long, grinding march to 1920 or 1982 types of bottom. So far, the overall valuations are high but the other signs that typically signal a market peak are absent, such as inverted yield curve, dramatically overbought sector (tech 2000, financials 2007), collapsing market breadth, falling earnings, etc.

    So I think the jury is still out, Will the economic recovery stay intact and slowly push revenues up to maintain earnings? That is the trillion dollar question.

    • rd says:

      BTW – it is unlikely that the Fed fully understood how much of their largesse would be routed into stock buybacks instead of capital investment. These days, many corporate executives rely on their stock options to make them wealthy because ofthe tax code preferences for capital gains. In a flat economy, stock buybacks is a good way to goose EPS when you can’t do it from the topline down. Meanwhile, this allows them to keep cutting costs (people) on their way to increased EPS without worrying too much about revenue.

      It is llkely that the US economy has borrowed as much or more long-term low interest rate capital to buyback stock (including taking companies completely private) over the past 5 years as the US government has borrowed to reconstruct our crumbling infrastructure. I don’t think this was the investment boom that Helicopter Ben had in mind.

      Maybe local and state governments should take a page out of the universities’ handbook and start lobbying wealthy executives for endowments for investments in infrastructure in their communities. They could get little placques put on pump stations and the like announcing that so and so made it possible.