In my last post, the big down and up move of CAPE from 1948 to the present was in part explained by a super cycle in interest rates.
Based on the interest rate super cycle one would have expected CAPE to go down from 1948 to 1980. And it should also have risen from 1980 to present. And that’s what happened. See green line on CAPE chart below. Price earnings ratios showing fair value were lower in the 1980s and higher in the 2010s. That is simply a reflection of the fact that interest rates were higher in the 1980s than in the 2010s. This is one reason why using a 100 year average of CAPE is a fundamental mistake. My last post is here.
There are other things at work. The blue line I have drawn on the CAPE chart shows the general trend of CAPE since 1948. It simulates what a linear regression through the data would show. There are as many data points above the line as below. There are several possible explanations for a general increase since 1948. One explanation would be that stocks have gradually become more expensive relative to fair value from 1948 to the present. I don’t think this is the case. There are other things happening in the world that provide an explanation. A fair value level for CAPE can change over time. We’ve seen how it can change based on interest rates.
Capitalism without capital
One problem with CAPE is one it shares with all price earnings ratios. It relies on reported or net earnings. Net earnings are not what they used to be.
Companies that create intangible assets internally are, with certain limited exceptions, required to expense the related cash outlays. As a result, the cost of creating major long-lived corporate intangible assets ends up reducing net or reported earnings while, at the same time, creating long-lived intangible assets that do not appear on the balance sheet.
While almost all business sectors are investing in intangibles and manufacturing seems to be growing intangible investments faster than the service sector, the impact is different in different sectors. For manufacturing companies, the growth of intangibles investment may serve to somewhat lower reported earnings. For the tech sector and some other sectors, the impact may be more dramatic.
Is this a big issue? You bet it is and it’s getting bigger. The following chart shows the relative share of company investment in tangible vs intangible investment. It comes from a wonderful book Capitalism without Capital, the Rise of the Intangible Economy (Haskel & Westlake, 2018).
I like the name of the book but I think it is misnamed. It should be ‘Capitalism without Tangible Capital’. Companies today like Facebook have capital. It’s just intangible.
The blue line I have drawn on this chart highlights the steady rise of U.S. business investment in intangibles from 1948 forward. The blue line correlates with the blue line on the CAPE chart above.
The interesting question is what impact this has on Price Earnings ratios. If companies are creating long lived intangible assets but expensing the cost annually, they will be creating long lived value but constraining their reported earnings. What one sees more and more in corporate financial statements is companies that have created substantial company franchises while at the same time showing constrained net earnings, the figure reported to the tax man and put in financial statements. Frequently these companies generate substantial Free Cash Flow as certain kinds of intangible asset are not only long lived but also do not require large capital expenditures to maintain their value. Companies will often accumulate large cash reserves and some even cannot see ways to allocate this excess capital profitably. The poster children are companies that have created intangible assets in the nature of organizational arrangements and processes (think Starbucks – 5yr av p/e 28.7), customer data (think Google – 5yr av p/e 34.3, Facebook – 5yr av p/e 50.4), subscribers (think Netflix – 5yr av p/e 214.1 ), networks (think Facebook), soft products like software with high switching costs (think Salesforce – 5yr av p/e 259.7) and brands (think Coca Cola – 5yr av p/e 45.7, Colgate Palmolive – 5yr av p/e 30.9). There are comparable examples throughout publicly listed companies. They often trade at what seems to be grossly high Price Earnings ratios but their Price to Free Cash Flow ratios are more modest. For a further look at this issue see here.
Reported earnings of companies are increasingly being lowered by the expensing of intangible investment while, at the same time, companies are making pots of money. This can be seen by healthy free cash flows, healthy cash balances and financial strength.
CAPE is a price earnings ratio. With the rise of the intangible economy one would expect a secular rise in fair value price earnings ratios and correspondingly, a secular rise in fair value CAPE ratios. And this is what is happening.
I am not saying this fully explains CAPE of 15 in the 1980s and CAPE of 25 in the 2010s. Like in my discussion of interest rates in my last post, I do say it is part of the explanation. And it is secular, unlike the super cycle of interest rates.
Since writing the above, Robert Shiller as cowritten an article that supports the ideas expressed above:
The Nov 30, 2020 article was written by ROBERT J. SHILLER, LAURENCE BLACK, FAROUK JIVRAJ and titled “Making Sense of Sky-High Stock Prices”.
They write: “….the level of interest rates is an increasingly important element to consider when valuing equities. To capture these effects and compare investments in stocks versus bonds, we developed the ECY, which considers both equity valuation and interest-rate levels. To calculate the ECY, we simply invert the CAPE ratio to get a yield and then subtract the ten-year real interest rate.
This indicates that, worldwide, equities are highly attractive relative to bonds right now.”
For readers wanting to dig deeper into the subject of how to allocate amongst different asset classes based on whether the market is cheap or expensive, take a look at Part 5: Asset Management.
In particular, see Chapter 28. Asset allocation.
And specifically to read further about CAPE see Sections:
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