In the past week we have seen two articles in the Financial Times about the United States stock market and a high-profile measure of whether or not the price of stocks are overvalued.
The measure in question has the acronym of CAPE, which stands for Cyclically Adjusted Price/Earnings Ratio. Yale economist Robert Shiller created the measure.
First, John Authers, a writer for the Financial Times, presented his views in the article "CAPE May Still Be Best Measure of Market Froth." This was quickly followed by rebuttal by economist Jeremy Siegel titled "Don't Put Faith in CAPE Crusaders." Authers quickly responded to Siegel"s piece with "CAPE Fear: Siegel Strikes Back."
In the first article mentioned above, Authers argues that, currently, most market signals are bullish, but the CAPE measure is one of the only indicators that is bearish. This leads Authers to write in the third article mentioned above that "the fact that CAPE is so bearish makes it unpopular," and that because of this, "bulls are now trying to show either that Shiller's CAPE was always flawed, or something has happened in the last decade or so to make the measure less useful."
This caveat, I believe, captures the essence of the whole debate. The bulls believe that the stock market should go higher. Siegel admits to being in this crowd: "Bulls, including myself, believe earnings are unlikely to fall and higher price-to-earnings (p/e) ratios may propel stocks even higher."
As a consequence, the bulls want to identify the statistics that support their beliefs and put down those statistics that do not support their case.
The same is true of the bears. As Mr. Siegel claims in his article, "The bears claim that current earnings are unsustainably high and can be expected to fall." It seems as if Authers falls into this category…just look at the title to his first article, "CAPE May Still Be Best Measure of Market Froth."
Authers does admit that CAPE is not the best measure to use for market timing "as once bubbles have become established they can reach levels of true insanity (as in 2000) before bursting."
He immediately follows this up with the statement "If interest rates are low and companies are disgorging cash at a record rate, as at present, stocks can stay expensive for a long time."
That is, stock prices can stay overvalued for a long time without a correction taking place. This fact, however, doesn't make the measure wrong. Timing is always an issue, with any measure used to predict the future.
The issue that Authers brings up that is important, I believe, for the discussion is whether or not we are in the presence of a bubble. And, this gets into the issue of whether or not bubbles can be identified.
For example, Ben Bernanke, Fed Chairman, is very sensitive about whether or not bubbles can be identified. This is brought out in an op-ed piece in the New York Times when economist Amar Bhidé writes "Under Mr. Bernanke and his predecessor, Alan Greenspan, it didn't foresee the housing bubble, much less try to pop it. Even if the Fed could identify bubbles, Mr. Bernanke once said…" I don't need to finish this sentence because Mr. Bernanke obviously implies that the Federal Reserve cannot identify bubbles.
Mr. Authers, in the quotes above, implies that we are in a stock market bubble. If this is so, then we need to be aware that bubbles can…and will…burst. CAPE is just providing information that the stock market appears to be overvalued and will, at some time in the future, correct itself.
One of the crucial points being debated is whether or not earnings will remain high and therefore justify the current level of stock prices. To reiterate what Mr. Siegel writes, "The bears claim that current earnings are unsustainably high…" whereas "Bulls believe earnings are unlikely to fall…"
In other words, bears believe that we are in a bubble. Bulls do not!
As readers of my blog posts know, I tend to be in the former category. I do not believe that given the current economic scenario, current earnings can be sustained. Even Mr. Siegel uses in his analysis a figure that is an important component of my analysis that real GDP growth, on a year-over-year basis, will continue, over the next five years or so, to grow only in the 2.0 percent to 2.5 percent range.
Siegel introduces this figure in determining his estimate of the real interest rate. He writes, Real interest rates (and hence yields on inflation-linked Treasury bonds) are strongly tied to GDP growth and if the "new normal" growth pessimists are right, real interest rates are unlikely to rise above 2.0 percent."
Note: that all Siegel's further analysis that supports his position that the stock market is not overvalued hinges on this assumption of 2.0 percent growth of real GDP.
In my analysis, if real GDP only grows by 2.0 percent over the next five years or so, current levels of earnings cannot be sustained. If current levels of earnings cannot be sustained, this means that current stock prices, based on expectations of future earnings, is over valued.
What, then, is causing the high value of stock prices? My answer is Mr. Bernanke and the Federal Reserve.
Mr. Bhidé states my position very well: "quantitative easing has amounted to an audacious experiment in trickle-down economics. Among other things, it has artificially boosted the stock market in the hope that enriching a few-the top 1 percent of American households owned 42 percent of the nation's financial assets in 2010-will help the many."
I couldn't agree with this more. See my post "Mr. Bernanke is Underwriting the Wealthy.'
So, yes, I am a stock market bear right now. And, I use CAPE to support my arguments. But, this doesn't mean that the debate (war) will not go on.