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.

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

Robert Shiller: Is he right that stocks are overpriced?

I frequently come across stocks such as Netflix [NFLX], trading on a forward PE of 137 (Morningstar), or even Coca Cola [KO] and Procter & Gamble [PG] that leave me muttering about unrealistic valuations.

Nobel laureate Robert Shiller this week commented that he was no longer buying stocks as he believed they were overvalued. His justification is the CAPE index which compares current stock prices to the 10-year average of inflation-adjusted earnings.

Shiller CAPE Index

The index is below its Dotcom high but is approaching the same level that it peaked at in 1929. Is the CAPE index flawed or does this portend disaster?

Bear in mind that Shiller is not selling all his existing stocks — he has merely stopped buying — and is the first to point out that the CAPE index is a poor tool for timing market tops and bottoms.

Before we make any rash decisions let us compare Shiller’s index to a few other handy measures of market valuation.

Warren Buffett’s favorite

Warren Buffett’s favorite measure of market value is to compare total stock market capitalization to GDP. The higher the ratio, the more the stock market is overvalued.

US Market Cap to GDP

This looks even worse than the CAPE index, with market cap to GDP well above its 2007 high and well on its way to Dotcom levels.

Adapting the ratio to include offshore earnings of multinational companies makes very little difference to the results. Here I compare market cap to GNP as well as GDP. GNP, or gross national product, includes offshore earnings of domestioc companies rather than just domestic earnings as with GDP. The end result is much the same.

US Market Cap to GNP

Market Cap to Corporate Profits

When we compare market capitalization to current profits after tax, however, valuations are still high but nowhere near the irrational exuberance of the Dotcom era.

US Market Cap to Profits after Tax

The current peak resembles earlier peaks in the 1980s and 1960s.

What this tells us is that corporate profits are rising faster than GDP. And that a 10-year average may be a poor reflection of future sustainable earnings.

Sustainable Earnings

Are current earnings sustainable? There is no clear answer to this. But there are some key criteria if earnings are to remain at current levels of GDP.

First, wage rate growth remains low. The graph below illustrates how profits fall when employee compensation rises (per unit of value added).

Wage Rates

Second, that interest rates stay low. The Fed is doing its best to normalize interest rates but monetary tightening would spoil the party. That is, deliberate tightening by the Fed to subdue rising inflationary pressures.

A third element is corporate taxes but there seems little risk of rising taxes in the current climate.

The key variable for both #1 and #2 is wage rates. At present these are subdued, so no cause for alarm.

Wage Rates

….yet.

Robert Shiller’s CAPE

I have long held the view that using Robert Shiller’s CAPE to determine whether stocks are under- or over-priced is misleading. Average levels for CAPE have shifted over time, and one cannot rely solely on historic highs and lows as a measure of whether the market is over-bought or over-sold.

So I was interested to learn that Robert Shiller currently maintains 50% of his investment portfolio in stocks. From an interview with Jason Zweig at WSJ:

Today’s level “might be high relative to history,” Prof. Shiller says, “but how do we know that history hasn’t changed?” So, he says, CAPE “has more probability of predicting actual declines or dramatic increases” when the measure is at an “extreme high or extreme low.” ….Today’s level, Prof. Shiller argues, isn’t extreme enough to justify a strong conclusion. So, he says, he and his wife still have about 50% of their portfolio in stocks.

Robert Shiller maintains exposure to stocks | WSJ

Jason Zweig writes:

Many analysts have warned lately that Prof. Shiller’s long-term stock-pricing indicator [CAPE] is dangerously high by historical standards…..If only things were that simple, Prof. Shiller says. “The market is supposed to estimate the value of earnings,” he explains, “but the value of the earnings depends on people’s perception of what they can sell it again for” to other investors. So the long-term average is “highly psychological,” he says. “You can’t derive what it should be.” Even though the CAPE measure looks back to 1871, using data that predates the S&P 500, it is unstable. Over the 30 years ending in 1910, CAPE averaged 17; over the next three decades, 12.7; over the 30 years after that, 15.7. For the past three decades it has averaged 23.4. Today’s level “might be high relative to history,” Prof. Shiller says, “but how do we know that history hasn’t changed?” So, he says, CAPE “has more probability of predicting actual declines or dramatic increases” when the measure is at an “extreme high or extreme low.” …..Today’s level, Prof. Shiller argues, isn’t extreme enough to justify a strong conclusion. So, he says, he and his wife still have about 50% of their portfolio in stocks.

Read more at Robert Shiller on What to Watch in This Wild Market – MoneyBeat – WSJ.

SHILLER: The Market Is At One Of Its Most Expensive Levels Of All Time…| Business Insider

Joe Weisenthal on Yale Professor Robert Shiller’s CAPE pricing model:

So while it’s true that the market is very expensive right now, based on his measure, [Shiller] notes that it’s difficult to use this information to actually time the market. Just because it’s expensive, doesn’t mean it will go down. Furthermore, the market has been expensive based on his measure for the past 20 years excluding the period of the recent crash, which raises the question of whether there’s been some fundamental change to the economy or markets that would warrant higher valuations.

Read more at SHILLER: The Market Is At One Of Its Most Expensive Levels Of All Time, And There's One Thing Can Take It Down | Business Insider.

Robert Shiller: CAPE should not be used for market timing

From an interview with Robert Shiller in January 2013:

Blodget: ….one frustration a lot of people have with the cyclically adjusted P/E and others is that it’s not particularly helpful for the timing mechanism, do you think it’s good to use as a sort of projected 10-year return, where when P/Es are high the return tends to be low, and vice versa?

Shiller: John Campbell, who’s now a professor at Harvard, and I presented our findings first to the Federal Reserve Board in 1996, and we had a regression, showing how the P/E ratio predicts returns. And we had scatter diagrams, showing 10-year subsequent returns against the CAPE, what we call the cyclically adjusted price earnings ratio. And that had a pretty good fit. So I think the bottom line that we were giving – and maybe we didn’t stress or emphasize it enough – was that it’s continual. It’s not a timing mechanism, it doesn’t tell you — and I had the same mistake in my mind, to some extent — Wait until it goes all the way down to a P/E of 7, or something.

Blodget: Right, perfectly safe, so then you can buy.

Shiller: But actually, the lesson there is that if you combine that with a good market diversification algorithm, the important thing is that you never get completely in or completely out of stocks. The lower CAPE is, as it gradually gets lower, you gradually move more and more in. So taking that lesson now, CAPE is high, but it’s not super high. I think it looks like stocks should be a substantial part of a portfolio.

Read more at Robert Shiller On Stocks – Business Insider.

Is the market overpriced?

David Leonhardt published this graph from Robert Shiller in his piece in the NY Times:

Shiller CAPE

I have one major issue with this: stock values are based on FUTURE earnings, not PAST earnings. The two are only related if earnings for the past 10 years are indicative of earnings for the next 10 years. I suspect that the next 10 years will present a whole new rash of unforeseen problems, but will be nothing like the last 10 years — any more than the period 2001 to 2010 resembles 1991 to 2000 (or 1981 to 1990).

Beware of the CAPE

I have just read John Mauldin’s warning that the market is overvalued:

Not only does today’s CAPE of 25.4x suggest a seriously overvalued market, but the rapid multiple expansion of the last few years coupled with sluggish earnings growth suggests that this market is also seriously overbought, as I pointed out last week and as we are seeing play out this week.

CAPE

Robert Shiller’s CAPE ratio compares the current index price to a 10-year simple moving average of inflation-adjusted earnings in order to smooth out earnings and provide a long-term indication as to whether the market is under- or over-valued. But ratios are far from infallible. One of the first things fundamental investors/traders learn is: do not buy a stock simply because the Price-to-Earnings (PE) ratio is low, and never short a stock simply because the PE ratio is high. The reason is fairly obvious. In the first case, current earnings may be expected to fall and, with high PE ratios, earnings are likely to grow.

Let’s examine CAPE more closely. First, we have experienced the worst recession in almost a century; so does a moving average of the last 10 years adequately reflect sustainable long-term earnings? In the chart below I removed the highest and lowest quarter’s earnings in the last 10 years [dark green]. Note the visible difference losses reported in Q/E December 2008 make to the long-term average.

Price Earnings Ratio

The chart also highlights the fact that Shiller’s CAPE is relatively low compared to the last 15 years, where the average is close to 30. The normal PE of 18.4, calculated on the last 12-month’s earnings*, is also low compared to an average of 28 for the last 15 years.

*Reporting for the December quarter is not yet completed and unreported earnings are based on S&P estimates.

As novice investors learn, it is dangerous to base buy or sell signals on a PE ratio, whether it is CAPE or regular PE based on 12-months earnings. Using CAPE, we would have sold stocks in 1996 and again in 2003, missing two of the biggest bull markets in history. And we would have most likely bought in 2008, when CAPE made a new 10-year low, right before the collapse of Lehmann Brothers.

I submit that CAPE or PE ratios are not an end in themselves, but merely a useful tool for highlighting expectations of future earnings. At present both ratios are rising, suggesting that earnings prospects are improving.