By Samuel Lee
I've basically sworn off exchange-traded notes, but when a Nobel-caliber economist creates one, I pay attention. I've made no secret of my admiration for Yale professor Robert Shiller. His research on stock-market volatility and intrinsic value persuaded me that markets aren't as efficient as I'd thought. I'm also a fan of cyclically adjusted price/earnings, or CAPE, a market valuation measure he and professor John Campbell popularized.
For those unfamiliar with this measure, CAPE is simply current price divided by the 10-year average of trailing earnings, adjusted for inflation. The original idea actually came from the father of value investing, Benjamin Graham, so it's sometimes called Graham-Dodd P/E. Other names include Shiller P/E and P/E 10. The measure smooths out the effects of the business cycle on earnings, providing a clearer view of the market's "true" earnings power. The measure has been shown to be a good predictor of long-term stock-market returns and is the basis of a lot of academic and practitioner stock-market forecasting models.
A Defense of CAPE
Barclays ETN+ Shiller CAPE ETN (CAPE), unsurprisingly, uses CAPE as its market-valuation measure. If you don't believe CAPE is a good valuation tool, then CAPE the ETN will look suspect. Many CAPE critics complain it provides an overly glum view of market valuations because it captures two big earnings busts, the biggest and most recent from the financial panic of 2008. Then again, it also captures two huge earnings booms. Moreover, the busts were short-lived, relative to history, in large part thanks to aggressive Federal Reserve money-printing and fiscal stimulus. Bizarrely, the solution CAPE's critics usually offer is to focus on 12-month trailing or forward operating earnings.
This is a horrible solution. As a general rule, you extend the measurement period the more volatile a time series in order to better cancel out the noise. The 12-month P/E, whether trailing or forecast, is procyclical, making equities look cheap during booms and expensive during recessions. I reserve special ire for operating earnings.
It's one of those things that sounds good in theory but often doesn't work in practice. Operating earnings, simply defined, is profits adjusted for one-off events in order to better represent the true earnings power of a company. If a company sells a unit, its reported profits will overstate earnings power. If a company pays a big one-time fine, its profits will understate earnings power. However, companies like to categorize bad surprises as singular events and good ones as recurring, leading to consistent overstatement of profits. Wall Street analysts play along because their employers do a lot of business with the firms they rate. The prospect of being fired for issuing too many negative opinions has a way of concentrating analysts' minds on the bright side.
CAPE's real weakness is that it's slow to account for permanent systematic shifts in earnings. These could include permanently lower corporate tax rates or permanently greater foreign earnings. Adjusting CAPE for these factors, however, doesn't change valuations by much because corporate taxes have been low for a while and foreign sales have been only slowly ramping up. According to the U.S. Bureau of Economic Analysis' National Income and Product Accounts, foreign profits accounted for 18% of all corporate profits in 2002 and grew to 24% in 2011. The aggregate corporate tax rate fell to 20% from 25% over the same period. Together, they might call for a modest adjustment to CAPE.
How CAPE the ETN Works
Even if you're not convinced CAPE is not an accurate gauge of stock market valuations, you can still learn a lot by looking at how CAPE the ETN is constructed. Shiller had a hand in formulating the strategy, and it shows. It's built on sound principles.
The ETN tracks the Shiller Barclays CAPE US Core Sector Index, which every month rotates its exposures to four of the nine S&P 500 Select Sector Indexes--the same ones the Select Sector SPDR ETFs track. The "Relative CAPE Indicator" indicates which sectors to pick. Because sectors have different earnings characteristics, naively picking the lowest-CAPE sectors would structurally bias the fund to low-growth sectors. In order to get around that, a sector's current CAPE is divided by the trailing 20-year CAPE average. The five sectors most undervalued according to the indicator are chosen. Then, the sector with the lowest 12-month price return is excluded. The remaining four are equally weighted.
The momentum screen is a nice touch. The cheapest sectors are often the most beaten-down, and because momentum is a powerful force in the markets, automatically picking up the cheapest stuff regardless of momentum often exposes you to extra volatility.
While I think the strategy is sensible, keep in mind that for most of its back-tested history, which only extends back to late 2002, it kept mostly to five sectors: energy, industrials, consumer staples, health care, and financials. The momentum screen kicked out financials right before the worst of the financial crisis, boosting back-tested returns. I'm almost somewhat uncomfortable with the short 10-year back-tested history. While I think Shiller has a lot of credibility as a careful economist, I'd feel more at ease if this strategy were shown to work over multiple decades and in foreign countries.
A version of this article originally appeared in the November 2012 issue of Morningstar ETFInvestor.
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