Fisher Investments Editorial Staff

Oddly Calculated, Bizarrely Inflation-Adjusted Thing Says Stocks Are Overvalued

By, 08/21/2014

Is the CAPE indicating the bull is about to expire? Source: Getty Images.

If you as much as skim financial news headlines these days, you’ve likely read the following: Stocks are overpriced. With many indexes bouncing back near new all-time highs (again!), the media has returned to bang the drum that investors are too rosy, setting up a fall. As evidence, many point to the cyclically adjusted price-to-earnings ratio (CAPE) being above its historical average as a sign a downturn looms. They aren’t alone. One of the CAPE’s inventors[i]—Nobel Prize-winning economist Robert Shiller—recently shared a similar sentiment in a widely read New York Times op-ed. In our view, though, there is ample evidence CAPE isn’t any more predictive today than it has been historically, and the chatter around it is a better sign investors aren’t euphoric than one they are.

CAPE compares stock prices with the past 10 years of inflation-adjusted earnings. Because corporate earnings fluctuate throughout business cycles, the creators wanted to make sure these gyrations didn’t skew the ratio, like when earnings growth is slower at the top of expansion or faster after cost-cutting coming out of a recession. Now, as we’ve written, valuations are not the be-all, end-all indicator of future market direction many presume. In our view, this is even more true of CAPE. Yet it’s still a media darling, and it has been all over the financial press all week—with many warning CAPE is not only above its average, but at levels similar to those seen in 1929, 1999 and 2007—ahead of three widely known bear markets.

But it is a bit bizarre to us to evaluate the future direction of forward-looking stocks using information a decade old.[ii] Especially bizarre since CAPE was never intended to be a cyclical forecasting tool, as its creator notes in his op-ed. It is an attempt to do the impossible: Forecast 10-year returns.[iii] But many try to twist it into a market timing tool—perhaps because CAPE was lauded for registering investors’ “irrational exuberance” in 1999. Never mind that the phrase was first trotted out in December 1996, three-plus years and 115.6% of S&P 500 Return before the actual market peak, figures that don’t seem like rounding errors or even in the ballpark to us.[iv] So that this same indicator is supposedly “hovering at a worrisome level” once again doesn’t mean you should cue up the ominous music. It also doesn’t mean three big years of solid stock returns necessarily await. It is just an oddly calculated, bizarrely inflation-adjusted thing.

Being an unreliable forecasting tool isn’t CAPE’s only flaw. Typical, non-“smoothed” ratios can be a signal of where sentiment is—a sign of how confident folks are today in a firm’s ability to grow earnings.  But CAPE’s structure also makes it a darn-near worthless indicator when it comes to gauging sentiment—for the exact same reason folks give it so much credence in the first place. Proponents argue CAPE’s using ten years of earnings provides more context—evening out cyclical ups and downs. But the economy is inherently boom-and-bust, and it’s not like that has no influence on earnings. For example, today’s CAPE ratio includes (and will include for the next few years) … wait for it … depressed earnings from 2008-2009 after the financial crisis! But earnings roughly six years old affected largely by the economic impact of an accounting rule that was put on a (hopefully permanent) vacation five years ago are highly unlikely to affect earnings growth looking ahead. All looking at long-term data does in this case is skew the comparison. Hence, CAPE says little about how much investors are willing to pay today for expected earnings.

For evidence of where sentiment really is today, we’d suggest other gauges might be more illustrative. For one, consider that MSCI World 12-month forward P/Es are right about their historical average. S&P 500 12-month forward P/Es are only a hair above theirs. That’s middling, not lofty. Another illustrative point: It so happens that a recent Gallup poll reflects this near perfectly. When US investors were asked how much they thought stocks rose in 2013, the plurality (37%) thought stocks gained only 10%. The next biggest bunch, 21%, thought the US stock market was flat. In fact, more respondents (9%) thought stocks went down than the 7% who answered up 30%—the closest answer to the actual result. It seems folks are not even aware of the big year, much less dancing euphorically and blowing birthday party blowouts[v] in front of a steamroller.

In our view, the investor who doesn’t fall prey to the CAPE crusaders can see this news for what it is: a sign skepticism lingers, which suggests to us the rampant euphoria typifying bull market tops remains far off.

i It’s odd to us this indicator is sometimes called, “The Shiller P/E,” considering he didn’t invent it alone. For the record, he co-created the ratio with John Y. Campbell in 1989. Shiller acknowledges this so we aren’t blaming him. We just guess “The Campbell P/E” was taken?*

*Yes, we know. It would be the Shiller-Campbell P/E. Or the Campbell-Shiller P/E. And yes, we just footnoted a footnote.

[ii] Even if the past was predictive, bear markets typically don’t last a decade. Selling out if you expect returns to be lower over the next ten years means investors could miss out on positive returns, too.

[iii] In the long run, supply and demand are the factors that will determine stock prices. We are aware of no tool that can forecast these factors accurately a decade out—especially supply, which would require an investment banker behavior model.

[iv] Source: Factset, S&P 500 Total Return, 12/05/1996 – 03/24/2000.

[v] These are those coiled kazoo-like party thingies that you blow into and they make noise and stuff. Like these here.


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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.


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