A Challenge To The Shiller P/E

| About: SPDR S&P (SPY)
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The elevated Shiller P/E ratio is often cited by market bears expecting low or negative forward returns on the U.S. stock market.

The Shiller P/E has great explanatory power with a high (low) multiple being consistent with low (high) forward returns.

Given that accounting rules have changed over time, S&P reported earnings also have varied, impacting historic examinations of earnings.

Professor Siegel substitutes NIPA data for S&P earnings and produces a metric with higher explanatory power, suggesting that stocks may not be as expensive as previously assumed.

Stock market bears are quick to point to the Shiller P/E ratio as the sign of an impending correction. Developed by Nobel laureate Robert Shiller, the Cyclically Adjusted Price-to-Earnings Ratio (CAPE) is an equity market valuation measure that divides the current index price by a moving ten-year average of trailing earnings, adjusted for inflation. Given the peaks in the ratio in 1929 (Great Depression) and 2000 (Technology Bubble), the Shiller P/E (graphed below) is oft cited as a warning signal for extended bull markets. With the current valuation at over 26x, this metric is 57% higher than its long-run average.

Source: Robert Shiller, S&P

Should we be concerned? Well, yes. Billionaire investor Cliff Asness of AQR Capital Management, a finance Ph.D., demonstrated in a 2012 white paper entitled: "An Old Friend: The Stock Market's Shiller P/E" that ten-year forward average returns fall as starting Shiller P/E's rise:

Source: AQR and Clifford Asness

The CAPE multiple has expanded further since that 2012 study and with the current market valuation now in that dreaded most expensive decile that has historically produced ten-year average inflation-adjusted returns of just 0.5% per annum, history suggests investors should expect subpar forward returns.

In a forthcoming paper in the Financial Analysts Journal, Jeremy J. Siegel, a finance professor at the Wharton School of the University of Pennsylvania, presents new data that might challenge the validation market bears see in the elevated Shiller CAPE. In "The Shiller CAPE Ratio: A New Look", Siegel points out that forecasts of future equity returns using the CAPE ratio may be too pessimistic given changes in the computation of earnings under Generally Accepted Accounting Principles. The rise of "mark-to-market" accounting, asset writedowns, and the belief that accounting standards have become more conservative in a post-Sarbanes Oxley world could be putting downward pressure on the earnings used in the CAPE ratio.

Siegel uses examples of the AOL writedown that was included in S&P 500 (NYSEARCA:SPY) earnings while the capital gain from the original sale of the company was excluded, and the outsized financial impairments in the 2008-2009 crisis of examples of how earnings volatility has increased. He pointed out that the decline in S&P reported earnings was greater in the most recent recession that in the Great Depression where the economic contraction was five times as large.

To test this assertion, Siegel uses consistent earnings data from the after-tax corporate profits in the National Income and Product Accounts (NIPA) compiled by the Bureau of Economic Analysis of the Department of Commerce. Accurate evaluation of the validity of the CAPE model valuation signal requires that the reported earnings series is consistent across time. The NIPA data provides that consistency, and with data back to 1928, has a long enough history to test through multiple business cycles.

When the NIPA data was substituted for the S&P earnings data, the forecasts of US equity returns increased meaningfully and the explanatory power of the CAPE model was further improved. For market bulls, this change did not make stocks cheap to historical levels, only less expensive. Using January 2015 as his measuring point, the overvaluation of the equity market drops from 54.6% to 18.8% when NIPA profits are substituted. Using a total return series of CAPE, which seeks to neutralize the impact of the shift towards accretive share buybacks versus the higher dividend yields of past periods, and the overvaluation of the market drops from 40% to 7.1% using NIPA profits.

Source: Jeremy Siegel

Substituting NIPA profits leads to lower multiples and higher expected forward returns. How much higher? The January 2015-January 2025 real returns forecasted by CAPE were just 2.2% per annum, but more than double that figure (4.41%) using NIPA profits. Forward returns would still be below the 6.7% long-term average real return on equities, but perhaps not as dire of an outcome as signaled by the CAPE method.

I still believe that forward returns in the U.S. stock market are likely to be subnormal, but examining data that may be disconfirming from your market view can sharpen your perspective. The Siegel analysis offers an insightful take on a well-documented market valuation tool, and details an important methodological shortcoming - time-varying accounting earnings - that should be taken into account when basing opinions of market valuation of the Shiller P/E.

Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.

Disclosure: I am/we are long SPY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.