Our last post looked at the issue of what is expected to happen as a country migrates from frontier to developed markets. We should expect to see the cost of capital fall in such a country. Among the reasons is that regulatory regimes, including protections for foreign investors, are typically strengthened. The falling equity risk premium demanded by investors results in rising valuations, arising CAPE 10.
There are also some other issues that have been raised about the use of the CAPE 10. One relates to the issue that far fewer companies pay dividends than was the case in the past. Today, something like 60 percent of U.S. stocks don't pay dividends, and 40 percent of non-U.S. don't pay them. In the U.S. that has resulted in the dividend payout ratio on the S&P 500 falling from an average of 52 percent from 1954 through 1995, to just 34 percent from 1995 through 2013. At least in theory, higher retention of earnings should result in faster growth of earnings as those retained earnings are reinvested. And that has been the case for this particular period as from 1954 to 1995 real EPS growth rate averaged 1.72 percent, and from 1995 to 2013 it averaged 4.9 percent.
The website Philosophical Economics features a useful article on this subject. The author explains that in order to make comparisons between present and past values of the Shiller CAPE, we need to normalize for differences in payout ratios. Making the adjustment between a 52 percent payout ratio (the average of 1954-1995) and a 34 percent payout ratio (the average since 1995) corresponds to around 1 point worth of Shiller CAPE.
The second issue relates to the change in accounting rules regarding writing off goodwill. As Philosophic Economics explains:
"In the old days, GAAP required goodwill amounts to be amortized-deducted from earnings as an incremental non-cash expense-over a forty year period. But in 2001, the standard changed. FAS 142 was introduced, which eliminated the amortization of goodwill entirely. Instead of amortizing the goodwill on their balance sheets over a multi-decade period, companies are now required to annually test it for impairment. In plain English, this means that they have to examine, on an annual basis, any corporate assets that they've acquired, and make sure that those assets are still reasonably worth the prices paid. If they conclude that the assets are not worth the prices paid, then they have to write down their goodwill. The requirement for annual impairment testing doesn't just apply to goodwill, it applies to all intangible assets, and, per FAS 144 (issued a couple months later), all long-lived assets."
While FASB 142 may be a more accurate method of accounting, it has created an inconsistency in earnings measurements with the present values end up looking more expensive relative to the past than they actually are. And the difference is dramatic. While the CAPE 10 as now measured is about 24.9, adjusting for the accounting change would put it about 4 points lower.
If we combine the two adjustments of 1 for the lower dividend payout and 4 for the FSB 142 change, the current CAPE 10 at 24.9 which looks way above the mean, doesn't look so overvalued at a now 19.9. In fact, that's right about in line with its average since 1960. Which begs the questions:
- Are stocks really overvalued or just highly valued (meaning returns are likely to be lower than historical levels, but that there is no reason to expect a major correction due to RTM)?
- To what mean should the CAPE ratio revert: The 16.5 mean of the past 113 years, or the 19.6 mean since 1960?
These three points - that over time it's logical to believe that the equity risk premium for U.S. stocks might have fallen, the accounting change regarding write offs, and the lower payout ratios - provide us with plausible explanations that the CAPE 10's high level is not signaling a massive overvaluation of U.S. stocks, setting the market up for a major correction as Jeremy Grantham, of Grantham Mayo van Otterloo, has been forecasting. As a caution, there might be some compelling "stories" on the other side. For example, some have stressed that changing executive compensation practices in the past 20 years have increased the incentives of executives to manage earnings. So at very least one should be cautious about using the Shiller CAPE 10 as a measure of whether is overvalued or undervalued.
In our final post in the series we'll provide some evidence on strategies that rely on RTM of valuations and summarize the issues facing investors.