The CAPE ratio; The good, the bad & the ugly

Is the CAPE ratio a decent way to demonstrate the value of shares? Well, indeed that’s still possible.

The CAPE ratio, or the Cyclically Adjusted Price Earnings ratio, is back in the news. The valuation measure of Nobel Prize winner Robert Shiller causes fear of height among investors and speculators. But how serious should we actually take the CAPE ratio?

I break down the CAPE proportion utilizing the well-known Western, The Good, the Bad and the Ugly.

The good

The Shiller PE, as the CAPE ratio is often called, is based on cyclically adjusted profits to determine market valuation.
For instance, recessions and / or accounting tricks will not have the capacity to render this valuation measure unusable. The attractiveness of the CAPE ratio is that it helps predict long-term returns.

In order to show this, I have depicted the American CAPE ratio for each calendar month since 1947 against the average annual return on the S&P 500 Index over the subsequent ten years.

The series of months is ranked from lowest to highest and then divided into five quintiles. In the first quintile, are one fifth of the calendar months with the lowest CAPE ratios, and in the fifth quintile are one fifth of the months with the highest CAPEs. The results are shown in the graph below.

The graph shows that in the ten years after the months with the lowest CAPE ratios, the return after deduction of inflation was 6.7% per annum. After the most expensive months, the ones in the fifth quintile, you would have earned almost nothing for ten years.

After inflation, a meagre 0.2% remained. For extreme values of the CAPE, the returns are even farther apart. In the sparse case of the CAPE falling below seven, you would have realized almost 10% return per year over subsequent ten years, while the S&P500 Index dropped by more than 5% per year with a CAPE of 40 or higher.

The predictive power of the Shiller PE does not hold for the US. Norbert Keimling from Star Capital determined the CAPE ratios for all countries in the MSCI World Index with a data history of 30 years or more.

Then he adds the CAPE ratios and associated returns of all calendar months from all exchanges together, resulting in the following image. This gives us a similar pattern: the higher the CAPE ratio, the lower – on average – the return.

The bad

So far the good news. The figure of Keimling also shows that the Shiller PE certainly does not always get it right. In fact, the benchmark does not yet account for even half of the future return.

That is nothing crazy of course, valuation is not the only factor that explains the long-term return on equities. Things like the economy, sentiment and politics, of course, also play an important role.

And especially don’t forget about the – sometimes unthinkable – grilling of investors. There are also factors closer to home that limit the prediction of the CAPE ratio. Take the stock market of Greece as an example.

What do the profits achieved over the past years say about the Greek stock market now? A large part of these companies simply no longer exists or their weighting in the index has been decimated.

You can expect the CAPE ratio to be less predictive in case of major structural changes in the composition of a stock exchange. Structural changes can also happen at other levels.

For example, suppose investors require structurally lower returns or risk premiums on their equity investments. For example, Japan, where the Bank of Japan has been purchasing shares on large-scale for many years, thereby directly supporting the market.

In this case, the valuation of shares can theoretically increase without this being accompanied by lower returns. And what about extremely low interest rates on bonds?

Those may be accompanied by structural higher CAPEs because stocks have become much more attractive compared to those expensive bonds. Jeremy Siegel, known for his book Stocks for the Long Run, comes with another criticism of the CAPE ratio, which has to do with the way profits are measured.

In calculating the CAPE ratio, Shiller uses reported earnings figures. However, Siegel argues that accounting rules push reported earnings during recessions now much harder down than in the past.

And since the large recession of 2009 is still in the current CAPE ratio, it is overestimated. Siegel therefore comes with a different profit definition, which is less sensitive to strict accounting rules, of course with the result that the CAPE is getting a little lower.

By the way, I am not really impressed with this last criticism. The profit measure Siegel uses is related to profits realised in the entire US economy, so including those of non-listed companies. This does not seem a justified way to me.

The ugly

Finally, the Shiller PE for the S&P500 Index shares is 29.2, or the highest point since 2002. That is of course not very good news. The first chart above suggests that real return on US stocks over the next ten years on average will not exceed 0%.

Keimling’s chart offers some relief because the actual realized returns can vary considerably from the average. At a CAPE ratio of 30, there was still a return of more than 10% per annum in the past.

However, I don’t expect the markets to maintain growing at 10%. It is mainly countries where structural changes in the composition of the stock market have taken place where we see such results.

Unfortunately, this does not hold for the S&P500 Index. And the story endorses that. Of the 23 months in which the US CAPE ratio was between 27 and 31, comparable to 29.2 where it is now, real return over the next ten years has only once been above 4%.

On the other hand, the return was eight times negative with a negative of 1.5% per year as the worst score. For the S&P500 Index, high valuation generally means a low return.

And what if we do take Siegel’s profit measure? Then the CAPE ratio will go down, but even then you cannot expect more than 2% return on US stocks over the next ten years.

But to not end in a depressive way: the CAPE ratio is significantly lower in other regions than in the United States!

Post Author: globaltrader24

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