PEmax and why you should be wary of Robert Shiller’s CAPE

Robert Shiller’s groundbreaking works, Irrational Exuberance and Animal Spirits, led to a Nobel prize in 2013 but we need to be careful of placing too much reliance on his CAPE as an indicator of stock market value.

What is CAPE?

CAPE is the cyclically adjusted price-to-earnings ratio, normally applied to the S&P 500, to assess future performance of equities over the next decade. CAPE is calculated by dividing the S&P 500 index by a moving average of ten years of inflation-adjusted earnings. Higher CAPE values imply poor future returns, while low values signal strong future performance.

Economists John Y. Campbell and Robert Shiller in 1988 concluded that “a long moving average of real earnings helps to forecast future real dividends” which in turn are correlated with returns on stocks. Averaging inflation-adjusted earnings smooths out short-term volatility and medium-term business cycles in the economy and, they argued, was a better reflection of a firm’s long-term earning power.(Campbell & Shiller: Stock Prices, Earnings and Expected Dividends)

Shiller later popularized the 10-year version (CAPE) as a way to value the stock market.

S&P 500 CAPE

Strengths

CAPE correctly identifies that the S&P 500 was over-priced in the lead-up to Black Friday (October 1929) and ahead of the Dotcom bubble in 2000. It also correctly identifies that stocks were under-valued after the Depression of 1920-21, during the Great Depression of the 1930s, and during the 2008 Global Financial Crisis.

Weaknesses

Some CAPE readings are rather odd. The rally of 1936, in the midst of the Great Depression, shows stocks as overvalued. Black Monday, October 1987, which boasts the highest ever single-day percentage fall (22.6%) on the Dow, hardly features. Current CAPE values, close to 30, also appear exaggerated when compared to current earnings.

Causes

There are several reasons for these anomalies, two of which relate to the use of a simple moving average to smooth earnings.

The simple moving average (SMA) is calculated as the sum of earnings for 10 periods which is then divided by the number of periods, 10 in our case. While the SMA does a reasonably good job of smoothing it has some unfortunate tendencies.

First, the SMA tends to “bark twice. If unusually high or low data is recorded, the SMA will rise or fall accordingly, as it should. But the SMA will also flag unusual activity, in the opposite direction, 10 years later when the unusual data is dropped from the average.

Second, the SMA is fairly unresponsive. If earnings rise rapidly, the SMA will lag a long way behind current values.

The third anomaly relates to the use of a moving average of earnings to reflect future earnings potential. Companies may incur losses at the low-point in the business cycle, especially in a severe down-turn like 1929 or 2008, but the impact on future earnings capacity is marginal.

Take a simplistic example, where earnings are $1 per year for 9 years but a loss of $5 is incurred in the following year.  When the business cycle recovers, potential earnings are likely to be $1, not $0.50 (the 10-year SMA).

Examples

All of these flaws are evident in the CAPE chart above.

Problem 1

Expect a fall in CAPE next quarter (Q1 2019) when losses from Q4 2008 are dropped from the SMA period.

Problem 2

Earnings multiples in the lead-up to Black Friday (1929) and the DotCom bubble (2000) are both overstated because of the lag in the SMA caused by rapidly rising earnings.

Problem 3

Potential earnings in 1936 are understated because of the sharp fall in earnings during the Great Depression, resulting in an overstated earnings multiple. The same situation occurs 2009-2018 when losses from 2008 inflate CAPE values.

Proposed Solution

I tried a number of different moving averages in order to avoid the above anomalies but all, to some extent, presented the same problems.

Eventually, I tried dropping the moving average altogether, instead using the highest previous four consecutive quarter’s earnings to reflect future earnings potential. I call this PEmax © (price over maximum historic earnings). PEmax matches normal historic price-earnings ratio (PE) most of the time, when earnings are growing, but eliminates the distortion caused by sharp falls in earnings near the bottom of the business cycle.

S&P 500 PEmax

PEmax overcomes distortions associated with the 1936 bear market rally, Black Monday in 1987 and our current situation in 2018.

Compare how the two perform on a single chart below.

S&P 500 PEmax compared to CAPE

The spikes on Black Friday and the Dotcom bubble are more muted on PEmax but still warn that stocks are over-priced relative to future earnings potential. The 1936 bear market rally is restored to its proper perspective. As is the 1987 Black Monday spike, by removing the distortion caused by declining earnings in the early 90s. The same happens after the Dotcom bubble. And again in 2009 -2018.

Potential Uses

The historic average (1900 – 2018) for PEmax is 12.79. For what it’s worth, standard deviation is 5.32 but this is not a normal distribution.

S&P 500 PEmax distribution

The median (middle) value is slightly below the mean, at 12.23.

Visual inspection of the data suggests that low values are skewed towards the first half of the 20th century. The average over the last 50 years (1969-2018) is 15.85 but, again, this may be distorted by the Dotcom era.

Based on visual inspection, we suggest using a PEmax of 15.0 as the watershed:

  • PEmax greater than 15.0 indicates that stocks are over-priced; while
  • PEmax below 15.0 presents buying opportunities.

Potential Weaknesses

PEmax has one potential weakness. If S&P 500 earnings are ever exaggerated by an unusual event, to a level that is unlikely to be repeated, potential earnings will be overstated and PEmax understated. Fortunately, that is likely to be a rare occurrence, where earnings for the entire index spike above actual earnings capacity.

Conclusion

PEmax ©, an earnings multiple based on the highest previous four consecutive quarter’s earnings, is a useful comparison of price to future earnings potential. It eliminates many of the distortions traditionally associated with price-earnings multiples, including CAPE. High PEmax values (above 15) suggest poor future performance, while low PEmax values (below 15) correspond with greater investment opportunity.

China’s newest export

“Polish authorities have arrested a Chinese employee of Huawei, the Chinese telecommunications giant, and a Polish citizen, and charged them with spying for Beijing, officials said on Friday, amid a push by the United States and its allies to restrict the use of Chinese technology based on espionage fears….
It is not the first time in recent months a Huawei employee has been arrested abroad. Meng Wanzhou, the company’s chief financial officer, was arrested in Canada last month at the request of the United States, where she had been charged with fraud designed to violate American sanctions on Iran….
A 2012 report from United States lawmakers said that Huawei and another company, ZTE, were effectively arms of the Chinese government whose equipment was used for spying. Security firms have reported finding software installed on Chinese-made phones that sends users’ personal data to China.”
From Joanna Berendt at The New York Times

Lack of independence of private companies in China, their use for espionage purposes including industrial espionage, and failure to open Chinese markets up to foreign competitors are likely to throttle attempts to resolve trade disputes with the US. An impasse seems unavoidable.

It is important that the West confronts China over their trade tactics, espionage and ‘influence’ operations. Whether Donald Trump is the right person to lead this, I will leave for you to judge.

I doubt that China wants to rule the world. Dominate, perhaps. But the overriding goal of their leaders is to ensure the survival of the Chinese Communist Party (CCP). They want to make the world safe for autocracy. They don’t seem to understand that this is an oxymoron. Autocracies make the world unsafe because they lack the checks and balances, imperfect as they may be, that ensure stable government in democracies whose citizens are protected by rule of law. If you think the world is already unsafe, imagine Donald Trump as president without the constraints of the US Constitution. History provides plenty of evidence of autocrats — Stalin, Hitler and Mao are prime examples — who abused their power with catastrophic results.

China’s newest export may be a global recession if world leaders are not careful. These two charts from the RBA highlight the current state of play.

Declining growth in retail sales is accelerating. Manufacturing PMI is rolling over and industrial production is likely to follow.

China Activity Levels

Output, on the other hand is surging, as the state attempts to spend its way out of a recession. Cement production is the sole laggard.

China Output

Matt O’Brien at The Age describes China’s dilemma:

…in the depths of the Great Recession, Beijing unleashed a stimulus the likes of which the world hadn’t seen since World War II.

It amounted to some 19 per cent of its gross domestic product, according to Columbia University historian Adam Tooze. By point of comparison, US President Barack Obama’s stimulus was only about 5 or 6 per cent of US GDP.

Aside from its size, what made China’s stimulus unique was the way it was administered. The central government didn’t borrow a lot of money itself to use on infrastructure, but it pushed local governments and state-owned companies to do so.

The result was a web of debt that’s been even harder to clean up than it might have been because of all the money that unregulated lenders – “shadow banks” – were frantically handing out above and beyond what Beijing had been hoping for….

What is new, though, is that this isn’t working quite as well as before. As the International Monetary Fund reports, China seems to have reached a point of diminishing returns with this kind of credit stimulus.

So much new debt is either going toward paying off old debt or toward economically questionable projects that it takes a lot more of it than it used to just to achieve the same amount of growth.

Three times as much, in fact. Whereas it had only taken 6.5 trillion yuan of new credit to make China’s economy grow by 5 trillion yuan per year in 2008, it took 20 trillion yuan of new credit by 2016.

I don’t share Matt’s conclusion that Wall Street fears the broad market will follow Apple (AAPL) into a tailspin as Chinese retail sales decline. I covered this in my last newsletter.

Nor do I think that falling Chinese steel production will plunge the global economy into recession. Though it would certainly affect Australia.

China has $3 trillion of foreign reserves and has shown in the past that it is prepared to spend big to buy its way out of a recession. Whether they succeed this time is uncertain, but old-fashioned stimulus spending will soften the impact.

I believe Wall Street has no idea how the trade dispute will play out. And financial markets have gone risk-off because of the uncertainty, despite a booming US economy.

Earnings ratios have fallen dramatically, back to 17.8, from what was clearly bubble territory above 20 times historic earnings. I use the highest preceding four quarters earnings, to smooth out earnings volatility, so my P/E charts (PEmax) will look a little different to anyone else’s.

S&P 500 PEmax

Market volatility remains high, with S&P 500 Volatility (21-day) above 2.0%. A trough above 1% on the next multi-week rally would confirm a bear market — as would an index retracement that respects 2600.

S&P 500

Momentum shows a strong bearish divergence.

S&P500 Momentum

Similar to the Dotcom era below. It would be prudent to wait for a bullish divergence, as in 2003, to signal the start of the next bull market.

S&P500 Momentum

I repeat the same quote as last week as an important reminder of current market volatility.

What beat me was not having brains enough to stick to my own game – that is, to play the market only when I was satisfied that precedents favored my play. There is the plain fool, who does the wrong thing at all times everywhere, but there is also the Wall Street fool, who thinks he must trade all the time.

~ Jesse Livermore

S&P 500 earnings surge

Of companies in the S&P 500 index, 90.2% have reported their results for the quarter. According to S&P Dow Jones Indices:

  • Sales growth at 11.0% year-on-year (Y/Y) is close to a potential record.
  • The earnings beat rate of 78% is also historically high, compared to an average of 67%.
  • Operating margins are at a record 11.58%, compared to an average of 8.08% over the last 20 years.

Forward earnings estimates are climbing, driving the forward Price-Earnings ratio to a more comfortable 17.6 compared to its March 2015 high of 23.9.

S&P 500 Forward Earnings Estimates

Valuations based on historic earnings remain high, but P/E multiples have fallen to 22.02 from 24.16 in the last quarter. The long-term chart below compares the index price to previous highest annual EPS, to eliminate distortions caused by sudden falls in earnings.

S&P 500 Price-earnings based on Maximum Previous Earnngs

The current earnings multiple is still significantly higher than the 18.86 reached prior to the 1929 Wall Street crash and 18.69 in October 1987. But high valuations don’t cause market crashes. Sudden falls in earnings do. And there is little sign of that at present.

The S&P 500 is retracing for another test of its new support level at 2800. Respect would signal an advance to 3000. Declining Money Flow warns of selling pressure but this appears secondary in nature, with the indicator still well above the zero line.

S&P 500

The Nasdaq 100 also warns of a correction, with bearish divergence on Twiggs Money Flow. Again this appears secondary in nature because of the indicator’s position relative to the zero line. Expect a test of support at 7000.

Nasdaq 100

Price & Earnings: The Race to the Top

Now that 93% of S&P 500 stocks have reported first quarter earnings we can look at price-earnings valuation with a fair degree of confidence. My favorite is what I call PEMax, which compares Price to Maximum Annual Earnings for current and past years. This removes distortions caused by periods when earnings fall faster than price, by focusing on earnings potential rather than necessarily the most recent earnings performance.

PE of Maximum Earnings

Valuations are still high, but PEMax has pulled back to 22.78 from 24.16 in the last quarter. Valuations remain at their highest over the last 100 years at any time other than during the Dotcom bubble. Even during the 1929 Wall Street crash (Black Friday) and Black Monday of October 1987, PEMax was below 20.

While that warns us to be cautious, as valuations are high, it does not warn of an imminent down-turn. Markets react more to earnings than to prices as the chart below illustrates.

S&P 500 Earnings per Share Growth

The last two market down-turns were both precipitated by falling earnings — the blue columns on the above chart — rather than valuations.

While it is concerning that prices have run ahead of EPS — as they did during the late 1990s — consolidation over the past quarter should allow earnings room to catch up.

Black Monday, October 1987

Cross-posted from Goldstocksforex.com:

What caused the Black Monday crash of 1987? Analysts are often unable to identify a single trigger or cause.

Sniper points to a sharp run-up in short-term interest rates in the 3 months prior to the crash.

3 Month Treasury Bill Rates

Valuations were also at extreme readings, with PEmax (price-earnings based on the highest earnings to-date) near 20, close to its Black Friday high from the crash of 1929.

S&P 500 PEmax 1919 - 1989

Often overlooked is the fact that the S&P 500 was testing resistance at its previous highs between 700 and 750 from the 1960s and 70s (chart from macrotrends).

S&P 500 1960 - 1990

A combination of these three factors may have been sufficient to tip the market into a dramatic reversal.

Are we facing a similar threat today?

Short-term rates are rising but at 40 basis points over the last 4 months, compared to 170 bp in 1987, there is not much cause for concern.

13-week T-Bill rates

PEmax, however, is now at a precipitous 26.8, second only to the Dotcom bubble of 1999/2000 and way above its October 1987 reading.

S&P 500 PEmax 1980 - 2017

While the index is in blue sky territory, with no resistance in sight, there is an important psychological barrier ahead at 3000.

S&P 500

Conclusion: This does not look like a repetition of 1987. But investors who ignore the extreme valuation warning may be surprised at how fast the market can reverse (as in 1987) from such extremes.

PEMAX second highest peak in 100 years

I published a chart of PEMAX for the last 30 years on Saturday. PEMAX eliminates the distortion caused by cyclical earnings fluctuations, using the highest earnings to-date rather than current earnings. The idea being that cyclical declines in earnings reflect a fall in capacity utilization rather than a long-term drop in earnings potential.

Since then I have obtained long-term data dating back to 1900 for the S&P 500 and its predecessors, from multpl.com.

PEMAX for November 2017 is 24.34, suggesting that stocks are over-valued.

S&P 500 PEMAX

Outside of the Dotcom bubble, at 32.88, the current value is higher than at any other time in the past century. PEMAX at 24.34 is higher than the peak of 20.19 prior to the 1929 Black Tuesday crash, and higher than the 19.8 peak before Black Monday in 1987.

This does not mean that a crash is imminent but it does warn that investors are paying top-dollar for stocks. And at some point values are going to fall to the point that sanity is restored.

Robert Shiller’s CAPE ratio

Here is Robert Shiller’s CAPE ratio for comparison. CAPE attempts to eliminate distortion from cyclical earnings fluctuations by comparing current index values to the 10-year average of inflation-adjusted earnings.

Shiller CAPE 10 Ratio

While this works reasonably well most of the time, average earnings may be distorted by the severity of losses in the prior 10 years.

You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.

~ Warren Buffett

CAPE v PEMAX: How hot are market valuations?

Robert Shiller’s CAPE ratio is currently at 32.17, the second-highest peak in recorded history. According to multpl.com, prior to the Black Tuesday crash of 1929 CAPE had a reading of 30. The only peak with a higher reading is the Dotcom bubble at 44.


Shiller CAPE - click to enlarge

Click here to view at multpl.com.

Shiller’s CAPE, or Cyclically Adjusted PE Ratio to give it its full name, compares the current S&P 500 index value to the 10-year average of inflation-adjusted earnings. The aim is to smooth out the earnings cycle and provide a stable assessment of long-term potential earnings.

But earnings have fluctuated wildly in the past 10 years, and a 10-year average which includes severe losses from 2009 may not be an accurate reflection of current earnings potential.

S&P 500 Earnings

The dark line plotted on the above chart reflects the highest earnings to-date, or maximum EPS. The market often references this as the current, long-term earnings potential, in place of cyclical earnings.

The chart below compares maximum EPS (the highest earnings to-date) to the S&P 500 index. The horizontal periods on max EPS reflect when cyclical earnings are falling.

S&P 500 and Peak Earnings

It is clear that the index falls in response to cyclical fluctuations in earnings (the flat periods on EPS max). But it is also clear that earnings quickly recover to new highs after the index has bottomed. In Q1 of 2004 after the Dotcom crash and in Q3 of 2011 after the 2008 global financial crisis.

The next chart plots the current index price divided by maximum earnings to-date. I call it PEMAX. When earnings are making new highs, as at present, PEMAX will reflect the same ratio as for trailing 12-month PE. When earnings are below the previous high, PEMAX is lower than the trailing PE.

S&P 500 PEMAX

What the chart shows is that, outside of the Dotcom bubble, prices are highest in the last 30 years relative to current earnings potential. The current value of 22.56 is higher than at any time other than the surge leading into the Dotcom crash.

The peak value during the Dotcom bubble was 30.19 in Q2 of 1999. The highest value in the lead-up to the GFC was 20.23 in Q4 of 2003.

Does the current value of 22.56 mean that the market is about to crash?

No. The Dotcom bubble went on for two more years after reaching 22.80 in Q3 of 1997. The present run may continue for a while longer.

But it does serve as a reminder to investors that they are paying top-dollar for stocks. And at some point values are going to fall to the point that sanity is restored.

The four most expensive words in the English language are “this time it’s different.”

~ Sir John Templeton