One of the most referenced valuation measures is Dr. Robert Shiller’s Cyclically Adjusted Price-Earnings Ratio, known as CAPE. Valuations have always been, and remain, an essential variable in long-term investing returns. Or, as Warren Buffett once quipped:
“Price Is What You Pay. Value Is What You Get.”
One of the hallmarks of very late-stage bull market cycles is the inevitable bashing of long-term valuation metrics. In the late 90s, if you were buying shares of Berkshire Hathaway, it was mocked as “driving Dad’s old Pontiac.” In 2007, valuation metrics were dismissed because the markets were flush with liquidity, low interest rates, and “Subprime was contained.”
Today, we again see repeated arguments about why “this time is different” because of ongoing beliefs that the Fed will bail out markets if something goes wrong. Of course, it is hard to blame investors for feeling this way, as it has repeatedly occurred since the “Financial Crisis.”
There is little argument, and as shown, current trailing valuations are elevated.
However, we need to understand two crucial points about valuations.
- Valuations are not a catalyst of mean reversions, and;
- They are a terrible market timing tool.
Furthermore, investors often overlook the most essential aspects of valuations.
- Valuations are excellent predictors of return on 10 and 20-year periods, and;
- They are the fuel for mean reverting events.
Critics argue that valuations have been high for quite some time, and a market reversion hasn’t occurred. However, to our point above, valuation models are not “market timing indicators.”The vast majority of analysts assume that if a measure of valuation (P/E, P/S, P/B, etc.) reaches some specific level, it means that:
- The market is about to crash, and;
- Investors should be in 100% cash.
This is incorrect.
Valuations Reflect Sentiment
Valuation measures are just that—a measure of current valuation. Moreover, valuations are a much better measure of “investor psychology” and a manifestation of the “greater fool theory.” This is why a high correlation exists between one-year trailing valuations and consumer confidence in higher stock prices.
What valuations do express should be obvious. If you “overpay” for something today, the future net return will be lower than if you had paid a discount for it.
Cliff Asness of AQR previously discussed this issue:
“Ten-year forward average returns fall nearly monotonically as starting Shiller P/E’s increase. Also, as starting Shiller P/E’s go up, worst cases get worse and best cases get weaker.
If today’s Shiller P/E is 22.2, and your long-term plan calls for a 10% nominal (or with today’s inflation about 7-8% real) return on the stock market, you are basically rooting for the absolute best case in history to play out again, and rooting for something drastically above the average case from these valuations.”
We can prove that by looking at forward 10-year total returns versus various levels of PE ratios historically.
Asness continues:
“It [Shiller’s CAPE] has very limited use for market timing (certainly on its own) and there is still great variability around its predictions over even decades. But, if you don’t lower your expectations when Shiller P/E’s are high without a good reason — and in my view, the critics have not provided a good reason this time around — I think you are making a mistake.”
So, if Shiller’s CAPE predicts long-term return outcomes with a long lag, is there potentially a better measure?
A Fly In The CAPE Ointment
As noted, valuations are a significant predictor of long-term returns. However, investors’ collapsing holding periods of equities have created a mismatch between valuations and expectations. Furthermore, extensive changes in the financial system since 2008 support the argument that using a 10-year average to smooth earnings volatility may be too long. These changes include:
- Beginning in 2009, FASB Rule 157 was “temporarily” repealed to allow banks to “value” illiquid assets, such as real estate or mortgage-backed securities, at levels they felt were more appropriate rather than on the last actual “sale price” of a similar asset. This was done to keep banks solvent as they were forced to write down billions of dollars of assets on their books. This boosted the bank’s profitability and made earnings appear higher than they may have been otherwise. The ‘repeal” of Rule 157 is still in effect today, and the subsequent “mark-to-myth” accounting rule is still inflating earnings.
- Another recent distortion is the heavy use of off-balance sheet vehicles to suppress corporate debt and leverage levels and boost earnings.
- Extensive cost-cutting, productivity enhancements, labor off-shoring, etc., are heavily employed to boost earnings in a relatively weak revenue growth environment.
- A surge in corporate share buybacks to reduce outstanding shares and boost bottom-line earnings per share to support higher asset prices.
The last point is one of the most significant supports of higher valuations in the previous 15 years. As noted in “Earnings Estimates Are Overly Optimistic,” buybacks have contributed to higher earnings per share despite lackluster growth in top-line revenue.
A Look At The Impact Of Buybacks
Since 2009, corporate reported earnings per share have increased by 676%. This is the sharpest post-recession rise in reported EPS in history. However, that sharp increase in earnings did not come from revenue. (Revenue occurs at the top of the income statement.) Revenue from sales of goods and services has only increased by a marginal 129% during the same period. As noted above, 75% of the earnings increase came from buybacks, accounting gimmicks, and cost reductions.
Using share buybacks to improve underlying earnings per share contributes to the distortion of long-term valuation metrics. As the WSJ article stated in a 2012 article:
“If you believe a recent academic study, one out of five [20%] U.S. finance chiefs have been scrambling to fiddle with their companies’ earnings.
This should not come as a major surprise as it is a rather “open secret.” Companies manipulate bottom line earnings by utilizing “cookie-jar” reserves, heavy use of accruals, and other accounting instruments to either flatter, or depress, earnings.
What is more surprising though is CFOs’ belief that these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share.“
Unsurprisingly, 93% of the respondents pointed to “influence on stock price” and “outside pressure” as the reasons for manipulating earnings figures. Such “manipulations” also suppress valuations by overstating the “E” in the CAPE ratio.
Another problem is the duration mismatch.
Duration Mismatch
Think about it this way: When constructing a portfolio containing fixed income, one of the most significant risks is a “duration mismatch.” For example, assume an individual buys a 20-year bond but needs the money in 10 years. Since the purpose of owning a bond is capital preservation and income, the duration mismatch is critical. A capital loss will occur if interest rates rise between the initial purchase and sell date 10 years before maturity.
One could reasonably argue that due to the “speed of movement” in the financial markets, a shortening of business cycles, and increased liquidity, there is a “duration mismatch” between Shiller’s 10-year CAPE and the current financial markets.
The chart below shows the annual P/E ratio versus the inflation-adjusted (real) S&P 500 index.
Importantly, you will notice that during secular bear market periods (shaded areas), the overall trend of P/E ratios is declining. This “valuation compression” is a function of the overall business cycle as “over-valuation” levels are “mean reverted” over time. You will also notice that market prices are generally “trending sideways,” with increased volatility during these periods.
Furthermore, valuation swings have vastly increased since the turn of the century, which is one of the primary arguments against Dr. Shiller’s 10-year CAPE ratio.
But is there a better measure?
Introducing The CAPE-5 Ratio
Smoothing earnings volatility is necessary to understand the underlying trend of valuations better. For investors, periods of “valuation expansion” are where the gains in the financial markets have been made over the last 125 years. Conversely, during periods of “valuation compression,” returns are much more muted and volatile.
Therefore, to compensate for the potential “duration mismatch” of a faster-moving market environment, I recalculated the CAPE ratio using a 5-year average, as shown in the chart below.
There is a high correlation between the movements of the CAPE-5 and the S&P 500 index. However, you will notice that before 1950, the movements of valuations were more coincident with the overall index, as price movement was a primary driver of the valuation metric. As earnings growth advanced much more quickly post-1950, price movement became less dominating. Therefore, the CAPE-5 ratio began to lead to overall price changes.
Since 1950, a key “warning” for investors has been a decline in the CAPE-5 ratio, leading to price declines in the overall market. The most recent decline in the CAPE-5 is directly related to the collision of inflation and the contraction in monetary policy due to increased interest rates. However, complacency that “this time is different” will likely be misplaced when the CAPE-5 starts its subsequent reversion.
The Deviation Matters
We can look at the deviation between current valuation levels and the long-term average to better understand where valuations are currently relative to history. It is crucial to understand the importance of deviation. For an “average,” valuations must be above and below that “average” over history. These “averages” provide a gravitational pull on valuations over time, which is why the further the deviation is away from the “average,” the more significant the eventual “mean reversion” will be.
The first chart below is the percentage deviation of the CAPE-5 ratio from its long-term average going back to 1900.
Currently, the 107.01% deviation above the long-term CAPE-5 average of 15.86x earnings puts valuations at levels only witnessed two (2) other times in history. As stated above, while it is hoped “this time will be different,” which were the exact words uttered during the five previous periods, the eventual results were much less optimal.
However, as noted, the changes that occurred post-WWII regarding economic prosperity, operational capacity, and productivity warrant examining only the period from 1944 to the present.
Again, as with the long-term view above, the current deviation is 90.15% above the post-WWII CAPE-5 average of 17.27x earnings. Such a deviation level only occurred twice in the last 80 years: in 1996 and 2021. Again, as with the long-term view above, the resulting “reversion” was not kind to investors.
Conclusion
Is CAPE-5 a better measure than Shiller’s CAPE-10 ratio? Maybe, as it adjusts more quickly to a faster-moving marketplace.
However, I want to reiterate that neither Shiller’s CAPE-10 ratio nor the modified CAPE-5 ratio were ever meant to be “market timing” indicators.
Since valuations determine forward returns, the sole purpose is to denote periods that carry exceptionally high levels of investment risk and result in abysmal future returns.
Currently, valuation measures clearly warn that future market returns will be substantially lower than they have been over the past 15 years. Therefore, if you are expecting the markets to crank out 12% annualized returns over the next 10 years so that you can meet your retirement goals, it is likely that you will be very disappointed.
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