In the last twenty years hardly a week has gone by without some analyst, commentator or pundit explaining that the stock market is over-priced and pointing to CAPE as evidence.
In this post I will explain where CAPE came from and where it stands today. A good place to start is where things stood about ten years ago when CAPE was the go to metric.
Back to 2013
The following chart of CAPE comes from an article in the Wall Street Journal, November 22, 2013. It displays what may be Professor Robert Shiller’s interpretation of CAPE as falling into three zones – green, yellow and red.
Robert Shiller was interviewed for the Wall Street Journal article. The CAPE reading at the time of the Wall Street Journal article was 25.2. This was higher than the CAPE long term average of 16.5 shown on the chart. The practical question that day was what actions investors should be taking in their portfolios at this level. The article reports: “At current levels, it’s a concern,” said the Yale University professor who last month won the Nobel Prize. It suggests “you should reduce holdings a bit, that might be reasonable.” In the meantime, it is possible “the market could keep going up even more.”
This yellow zone/red zone interpretation means that one would not be in a true danger zone until CAPE gave a reading over 28.8. A reading of 25.2 (at the time of the article) is pretty well in the middle of the yellow zone. It is not clear whether the green/yellow/red zone distinction is Robert Shiller’s or the Wall Street Journal’s. I doubt the Wall Street Journal would have published the zone colours without Shiller’s concurrence. I do note that Shiller said that the reading of 25.2 was “a concern”. The suggestion, one supposes, is that the stock market at that time was priced fairly richly.
Shiller wrote the first edition of his book Irrational Exuberance during 1999, at the height of the dot com bubble. With reference to the CAPE ratio, he wrote in the book: “Long-term investors would be well advised, individually, to lower their exposure to the stock market when it is high, as it has been recently, and get into the market when it is low.”
Shiller’s basic claim for CAPE was expressed this way: “The relation between price-earnings ratios and subsequent returns appears to be moderately strong…” and that, “We believe, however, the relation should be regarded as statistically significant.” (Shiller, Irrational Exuberance, 2005 Second Edition) p.187. All this means is that a high CAPE suggests lower expected returns. He presented no evidence that it could be used as a market timing tool. Specifically, he presented no evidence that one should lower one’s exposure to the stock market when CAPE was high. i.e. use it as a tactical asset allocation metric.
Fast forward to today
Here’s CAPE today. It’s approaching the mid 30’s. Based on the 2013 article, the stock market passed into the above 28.8 danger zone some time ago. Should we be running for the hills? By the way, TR CAPE is a total return CAPE, a modification brought in a few years ago to address one shortcoming.
Upside down CAPE
Enter the matter of interest rates. You will notice that the dotted red line on the above chart shows long-term interest rates. It is clear that the period from 1960 to 2020 shows a dramatic rise and fall of interest rates. On Nov 30, 2020, ROBERT J. SHILLER, LAURENCE BLACK, and FAROUK JIVRAJ published a paper titled Making Sense of Sky-High Stock Prices. They tell us: “…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 [Excess CAPE Yield] 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.”
They explain: “This measure is somewhat like the equity market premium [Equity Risk Premium] and is a useful way to consider the interplay of long-term valuations and interest rates. A higher measure indicates that equities are more attractive. The ECY in the US, for example, is 4%, derived from a CAPE yield of 3% and then subtracting a ten-year real interest rate of -1.0% (adjusted using the preceding ten years’ average inflation rate of 2%).” (Emphasis added)
The authors’ state: “…a key takeaway of the ECY indicator is that it confirms the relative attractiveness of equities, particularly given a potentially protracted period of low interest rates.” (Emphasis added) See article here.
Here’s the kicker
We were previously told that CAPE over 28.5 was in the danger zone. Now we are told that with CAPE over 30, low interest rates and the ECY “confirms the relative attractiveness of equities.” These two statements cannot stand together. The following chart shows the Excess CAPE Yield (ECY) up to the January 2022.
My assessment of CAPE
Frankly, I don’t think that CAPE, by itself, ever really told us anything. First, CAPE misses the whole concept of stock values being based on discounted cash flows and having a proper discount rate based on risk free 10 year treasury rates. That is, CAPE is ignorant of interest rates. See my post here.
Secondly, the use of an average CAPE over 100 years made no sense at all. See my post here.
Third, over the last 120 years the equity risk premium seems to have been in a long term secular decline. That is, over the 120 year period stocks have come to be seen as less risky. That may be a result of better market regulation, better accounting standards, better disclosure requirements, and perhaps other things. This is a secular change. See my post here.
Fourth, CAPE is a price earnings ratio. As such, one critical input is earnings. That is, net reported earnings. A significant problem today is that many companies’ spending is focused on intangibles which often create long lasting valuable assets. The kicker is that this spending is being expensed and thereby reducing reported earnings. This is not like the old days when company investment in tangible capital assets was added to the balance sheet and amortized over time. The world has changed and reported earnings and CAPE are not keeping up. See my post here.
Recent report from Goldman Sachs
A January 2022 report by the Investment Strategy Group at Goldman Sachs looks at the question of whether the underlying premise of CAPE is sound. Interpreting and using CAPE is based on the statistical idea that many data series revert to the mean. This is the statistical underpinning of the use of the 100 year CAPE long term average of 16.5. But the math folks at Goldman Sachs report that CAPE doesn’t revert to the mean. They write: “The statistical significance over the full sample is 26%. This means that there is only 26% confidence that the Shiller CAPE is mean-reverting, and 74% confidence that it is not. The traditional threshold to consider a relationship statistically significant is 95%.” Goldman Sachs report P.16. The simple fact is that lots of data series do not revert to the mean. Some do. Some don’t. It’s something we have to be mindful of around investing.
Goldman Sachs continues: “Even if we ignored this threshold, the time between valuations crossing into their 10th decile and reverting to their long-term average is beyond a reasonable investment horizon for a tactical decision.” In plain English this means that CAPE is not useful for shifts in stocks weightings, i.e. tactical asset allocation. So from a statistical point of view, lightening up on stocks when CAPE is higher won’t do it for you. For Goldman Sachs report see here.
CAPE has enjoyed a halo for years. The idea of smoothing out the stock market price earnings ratio is not a bad idea. Graham and Dodd point out in their 1934 book Security Analysis, price earnings ratios can vary a lot because earnings vary a lot over the business cycle. Graham and Dodd suggested employing a multiyear average of earnings.
In 1988 John Campbell and Robert Shiller published a paper using a ten year average. CAPE has been widely used and followed over the last 30 years. It’s not that the numbers are wrong. The problem is that the interpretation is mistaken. It’s best to simply ignore it. It’s just too facile to say because CAPE is over 30 the stock market is overpriced.
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