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CAPE – Cyclically Adusted Nonsense?

Want to Stand Out in a Crowd? Take a Closer Look at Cyclically Adjusted Price/Earnings Ratios, says Michael Wilson

You know how everyone hates a party pooper. He’ll wait until the festive mood is really starting to go somewhere, and then he’ll open his mouth and tell you exactly why everybody else in the room is getting it all wrong and we’re all far too cheerful. The trouble is, sometimes it turns out that he’s the only guy in the room who’s talking sense. And it’s only afterwards that you notice. But you still hate him anyway. Because he’s a party pooper, full stop.

That’s the way some people are feeling these days about Cyclically Adjusted Price/Earnings Ratios (CAPE) – the one and only truly bearish indicator in the stock market constellation at the moment. Every other popular indicator you can name – trailing p/es, forward p/es, even dividend yields – is currently telling us that shares are cheap, or at worst fairly valued. But the CAPE boys are insistent that the stock market recovery has gone quite far enough, thank you, and that the ‘real’ level of share prices in relation to corporate earnings is 50% higher than its long-term average.

For instance, they say, America’s S&P 500 index isn’t running at an affordable 17, as we all think – it’s actually heading for 25, which means it’s heading for bubble territory. Especially since the long term CAPE average is closer to 16.5.

What are we supposed to do with these people? Well, listening to their arguments would be a good start. It’s certainly clear enough that their metrics are different from ours. But is there any value in them?

CAPE of Tranquility, CAPE of Despair

The first thing to say about CAPE ratios is that they aren’t new. Some 75 years ago, Ben Graham and David Dodd were bemoaning the fact that conventional trailing p/es could be kicked about quite mercilessly by the changing fortunes of the business cycle – for instance, because a market emerging from a period of low profit would throw unnaturally large p/es at us, while a market entering recession might sustain attractively low p/es for much longer than was sensible. Dodd and Graham proposed that, instead of focusing on the last year’s profits, we should improve the stability of the calculations by taking a five or ten year average of prices and earnings.

The calculation was refined in the 1980s by Professor Robert Shiller of Yale Unversity, who famously proposed that we should also index our backward figures to allow for inflation over a 10 year period. And that’s the model that we use today. The CAPE calculation is intended to smooth out the waves and give us a less storm-tossed view of where we really are.

Unfortunately that’s where things get complicated, because the mathematics of CAPE calculations are more complex than most of us have time for, and even senior economists tend to rely on third-party sources. You’ll struggle to find consistent estimates, but a downloadable spreadsheet at http://www.econ.yale.edu/~shiller/data/ie_data.xls gives Shiller’s own fascinating view of how the US market has behaved since 1880, while http://tinyurl.com/nhzaz3f has a brave but more limited stab at applying the calculation to the FTSE-100 between 1993 and end-2012.

What the charts show is that CAPE figures can be really very volatile indeed. During the dotcom boom of the late 1990s, the S&P 500 CAPE hit a startling 44 before dropping back to 15 in 2006. In the last few years, CAPE calculations for both the London and the US markets have run at 4-5 points higher than the mainstream indices – suggesting, the enthusiasts say, that although still well short of all-time highs (even the FTSE CAPE touched 30 in 1999), they are still above the long-term averages.

No Shortage of Knockers

One thing you’ll notice from Shiller’s own charts, if you follow our eartlier link, is the central role that he attaches to long-term interest rates, which he says are intimately connected to the way that ‘real’ p/es behave. Fair enough – they do, after all, help to determine bond yields, which feed into share price performances.

But that’s where the knocking from the sceptics starts. The CAPE calculations, they agree, did a marvellous job of warning in 1999 that the markets were set for a terrible fall – and that the rally of 2001 would end in tears. But they have twice failed to tell us – notably in early 2011 – that stocks were cheap and that a major upgrade of equity markets was on the cards. The 31% bull market since then has been something of an embarrassment.

Besides, they say, the long-term calculations have been skewed over the years by failing to take all sorts of developments into account – large write-offs in the 1990s, changes in the tax environment, and most recently the consistently low inflation figures and lending rates. And they’ll batter you with reasons why changes in profits performance have made the Shiller method look stupid.

Yet the enthusiasts are still there, and they’re still itching to tell us we’re wrong. What’s more, some of the world’s most distinguished commentators are now coming out on the bears’ side. John Authers at the Financial Times is just one of the leading figures who are increasingly urging us not to throw the baby out with the bathwater – because although, as Authers concedes, CAPE is a flawed measure, its findings still speak to the gut feelings of those with more experience than you or me.

We’ll leave it there, I think. We really wouldn’t have enough room here to give you much more detail than this – but, if we’ve whetted your appetite, do take a closer look.

And if you think the whole thing is bunkum, tell us that as well. We’ll be glad of any comments you may like to send to our website at www.ifamagazine.com.

 

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