A DISPUTE about a stock valuation indicator between two academics doesn't sound like a critical matter. But, when the argument concerns two of the world's leading market historians and the likely long-term returns of the US stock market, investors need to pay attention.
The US stock market, which accounts for more than 50 per cent of global market capitalisation and affects pensions everywhere, is up over 150 per cent since March 2009. Bulls, such as finance professor Jeremy Siegel, author of Stocks for the Long Run, say stocks remain cheap.
However, Prof Robert Shiller, who famously predicted the dotcom crash of 2000 and the housing collapse later in the decade, says the S&P 500 is more than 40 per cent above its long-term average.
The Shiller PE – also called Cape, for cyclically adjusted price-earnings ratio – averages earnings over 10 years. One-year P/E ratios seemed reasonable in 2007 but earnings were unsustainable, as flagged by high 10-year Cape readings.
Similarly, stocks traded at over 100 times earnings in early 2009, following the profits collapse, but Cape stood at a multi-decade low, indicating bargain time.
Today, the S&P trades on a Cape of 23.8 compared to a long-term average of 16.5.
The indicator, which captured the market crashes of 1929, 2000 and 2008, has been the “single best forecaster” of equity returns, Siegel acknowledges, but dodgy data means it is now unreliable.
"Don't put faith in Cape crusaders," Siegel wrote in the Financial Times last month. Accounting changes in the 1990s saw companies take large writedowns if their assets fell in price, but earnings were not boosted if they rose in price, unless they were sold. This led to downwardly biased earnings, he said, and low earnings led to high Cape readings.
Between 1955 and 2000, said Siegel, S&P profits moved in line with after-tax profits published in National Income and Product Accounts (NIPA). That changed after 2000, with S&P profits much more volatile than NIPA’s. Substitute NIPA profits for S&P 500 profits, and Cape no longer looks expensive.
Siegel aside, brokers and bulls have long hated Cape’s inconvenient readings. Many (including Siegel) argued current Cape readings are distorted by 2008’s unprecedented profits collapse.
That ignores artificially inflated earnings prior to 2008, however, as well as the enormous profits rebound. Even if one strips out 2008/09 earnings, Cape is only mildly lowered.
The accounting charge is different. Shiller, an old friend of Siegel’s, has not responded in great detail, although the two are set to engage at a conference next month. He has promised to read Siegel’s “complicated” paper “sympathetically” but would “stick with” Cape.
British analyst Andrew Smithers, whose widely followed Q ratio has long produced similar readings to Cape, told the FT that US earnings are indeed more volatile since 2000, but not for the reason suggested by Siegel.
Rather, it is due to executive compensation being tied to share price rises. Large writedowns can be seen as an admission that past profits were overstated, he said, or a promise to overstate them at a later date.
Perhaps, but all kinds of secular changes certainly could diminish Cape’s predictive power. One analyst has argued that a Cape adjusted for tax changes looks much less frothy.
Others note Cape readings have steadily risen over the last century, and that earnings data from 100 years ago may be of limited relevance to market valuations today.
Long-term returns
One thing Cape is not is a simple market-timing tool. It missed the 2003-07 bull market and most of the current rally. This year's Global Investment Returns Yearbook notes Cape readings screamed "sell" in 1995 and did not hit value territory until 2009. During that time, stocks returned 5.75 per cent annually – not brilliant, but not bad.
However, Cape was never a simple buy/sell signal. Rather, it indicates if investors should overweight or limit exposure to certain assets or sectors (there are now exchange-traded funds that focus on sectors with low Cape ratios).
Studies by investment manager Mebane Faber indicate that countries with the lowest Cape readings – generally, perceived basket cases – have trounced long-term returns on offer from those with the highest readings.
In recent years, the S&P 500 has looked pricey but Europe has been at bargain-basement levels, with obvious asset allocation implications.
Back in 2000, mean-reverting investor Jeremy Grantham was dubbed a perma-bear for his views on developed markets but he was a raging bull on emerging equities, which subsequently multiplied even as others entered a lost decade. Similarly, investors approaching retirement might use Cape to take an appropriately defensive posture.
Anti-Siegel commentators, such as Société Générale's Andrew Lapthorne, say Cape may have its "idiosyncrasies" but various other valuation metrics indicate the US market is expensive.
Faber says a composite of five separate metrics indicates the US is one of the most expensive markets in the world. Warren Buffett’s favourite indicator, US stock market capitalisation relative to GNP, suggests modest overvaluation.
Empowering investors
Mean-reverting investors, too, note US profit margins are 25 per cent above their 10-year moving average, indicating earnings – as suggested by Cape – are unsustainable.
It would be naive to assert that no tweaks to Cape will ever be necessary, as if it is somehow impermeable to time. However, it remains important to ordinary investors, for two reasons. One, it is, as Shiller says, “easy to explain”, empowering investors befuddled by meaningless broker-speak. Second, even if US data is suspect, the ratio has proved historically valuable for assessing global markets and sectors in general.
As for the US, Siegel expects the Dow index, currently 15,400, to hit 18,000 next year. Shiller, meanwhile, is no inveterate bear, saying US markets are not bubbly, as they were in 2000 and 2007. He predicts low but real returns over the next decade.
“I’m not really saying ‘don’t invest in stocks’,” he said last week. Just ‘don’t expect miracles’.”
