The U.S. Stock market has passed the 8th anniversary of its bull run. Since the nadir of the subprime crisis, the S&P 500 has returned almost 300%. Even as equities soar to new heights, there is a persistent chorus of opinion that the U.S. stock market is overpriced relative to its fundamental value.
One of the most cited voices has been Robert Shiller, professor of economics at Yale University. He developed a stock market valuation model based on the price/earnings ratio. The innovation here is that many years of earnings are smoothed to arrive at a more stable measure of value. It is known as the cyclically adjusted priced earnings ratio or CAPE.
Recently, Shiller summarized his own measured concerns in a New York Times article:
Important measurements - some of which I developed - tell us that the market is quite expensive and that investor optimism is tinged with plenty of worry... returns over the next decade or so are likely to be constrained.
Shiller has an intellectual combatant. Jeremy Siegel of the Wharton School of business agrees that the price/earnings ratio has some forecast value. However, he believes that Shiller's model is misspecified. When corrected, the CAPE ratio reveals a stock market that is more fairly priced.
This article will weigh the pros and cons of the CAPE ratio. We'll rely in part on some distillation of Shiller and Siegel's research. There will also be observations on the economy as a whole and its effect on stock valuation.
Origins of the Shiller P/E Multiple
The intellectual roots of the Shiller's CAPE reach back to the early 1930s with the famous value investors Benjamin Graham and David Dodd. Their classic text, Security Analysis, argued that a single year's earnings would be too volatile to evaluate a company's real value in the marketplace. To control for cyclical effects, Graham and Dodd recommended dividing price by a multi-year average of earnings and suggested periods of five, seven or ten years.
Robert Shiller and his colleague, John Campbell, ultimately selected ten years of earnings data and adjusted each observation upward for observed inflation. Their CAPE ratio gained public attention when the authors presented their findings to the Board of Governors of the Federal Reserve on December 3, 1996. There, they warned that recent earnings levels could not support prevailing stock prices. Shiller and Campbell's research found a negative correlation between the CAPE ratio and the stock market performance over the next ten years. A high current CAPE ratio portended poor future stock returns.
Are Price/Earnings Multiples Comparable over Time?
Jeremy Siegel has has argued that the earnings time series that Robert Shiller uses has changed substantially - in a manner that depresses observed earnings. Siegel opined in the Economist in 2015:
My point is that the earnings series that Mr. Shiller uses has changed substantially since he developed the model some 20 years ago. The mandates of the Financial Accounting Standards Board in the 1990s required firms for the first time to employ "mark-to-market" accounting, a procedure which greatly increased the volatility of reported earnings. Such volatility was particularly evident in the recession that followed the financial crisis when reported earnings fell by a much greater percentage than they had during the Depression of the 1930s, a slump that was five times as great.
One of the most common criticisms of the Shiller findings is the persistence of high CAPE ratios over the past quarter century. Since 1988, there have been only 7 months when the CAPE ratio fell below its historical average to that point. This is hardly behavior one would expect to find in a mean reverting measure, especially when our economy has experienced such deep cycles over that time frame.
There have been three recessions in the last 29 years, interspersed with economic growth that has driven stock prices upward at a rate exceeding 10% per year. Yet the CAPE metric has stubbornly flashed a bearish signal. That just doesn't feel right.
When Shiller and Campbell spoke to the Board of Governors, the signaling properties of the CAPE seemed more symmetric. It spent about the same amount of time in bullish and bearish ranges from 1881 through 1996. Since their paper was published, the CAPE has been pretty much stuck as a sell indicator except for a brief period at the depths of the subprime crisis.
The current CAPE ratio, as reported by Shiller is 29.2, almost twice its long term average since the late 19th century. The research assembled by Dr. Shiller suggests that the S&P 500 returns over the next ten years should be below par. In recent decades, however, the realized returns of the S&P 500 have consistently outperformed the forecasts of the CAPE ratio.
One possible explanation for the persistent expansion in price/earnings multiples has been the secular decline in market interest rates. Equity investments do not exist in a vacuum. They are part of a financial ecosystem that includes alternative stores of value. Bonds and cash are an obvious substitute for stock ownership.
It's no secret that interest rates have fallen over the last 35 years. Since the Great Recession, the world's central banks have reduced short term rates to near zero while long term rates have hovered around 2%. This coordinated financial repression has bolstered stock market valuations in two ways.
Low interest rates mean that future corporate earnings are discounted less in the computation of stock value. A dollar earned five years from now is much closer to a dollar earned today. All else equal, price/earnings ratios should increase in a low interest rate environment.
Depressed interest rates also reduce the allure that cash and bonds hold as a substitute for stocks. S&P 500 dividend yields have surpassed interest on treasury bonds in recent times. Today's S&P 500 dividend yield is about 2.3%, even higher than the yield on a 10 year treasury bond. Moreover, the the volatility of the S&P 500 is at a generational low. For investors seeking current income, stocks look pretty good even at these high price/earnings multiples.
Alternative Specifications of Earnings
The Bureau of Economic Analysis (BEA) compiles earnings data in a manner somewhat different from that reported by public companies under generally accepted accounting principles (GAAP). The BEA calculates earnings based on current production only. Long term gains and losses are excluded. Even depreciation is restated to reflect real economic wear and tear rather than a schedule mandated by GAAP.
The data compiled by the BEA may or may not be more accurate than that compiled under GAAP. However, these earnings are smoother over time and less susceptible to accounting and corporate policy changes. Jeremy Siegel used the BEA earnings rather than GAAP earnings to compute the CAPE ratio. There were two interesting results.
The first is that the BEA's earnings did a better job of explaining actual stock market performance. And secondly, the stock market seems more fairly valued under the alternative earnings measure. Using data available through early 2014, the U.S. stock market is only about 10% to 20% overvalued.
What the Near Future Holds
The composition of the CAPE ratio allows us to make some reasonable forecasts of its direction based on the historical data and near term earnings expectations. Remember - earnings from the last 10 years comprise the denominator of the CAPE computation. Ten years ago, America was on the cusp of a major recession which gutted corporate earnings for three years. That data will soon roll off the CAPE calculation and be replaced by more robust present day earnings.
We can also use forecasts of corporate earnings to gain additional insight into the near term direction of the CAPE measure. Last week, Factset published its latest summary of consensus earnings forecasts for the S&P 500 through year end 2018. It was quite positive with annual growth rates at or above 10%. Even revenue is expected to grow at a 5% rate.
So... the near future does suggest some tapering to the CAPE ratio. Between now and year end 2020, some very low earnings from 2008 through 2010 will be replaced by higher contemporary numbers in the CAPE computation. Moreover, earnings growth at one half of forecast should still accrue at 5%. Bottom line, the CAPE measure would fall below 25 if the S&P 500 level stayed the same. That's still high but well within historical precedent.
The U.S. and Foreign Markets
Since the last recession, the American stock market has substantially outperformed foreign equities. Domestic stocks have outperformed foreign markets by more than 7% annually since the nadir of the last recession! Many investors have become skittish about foreign investing as a result of this prolonged slump.
Longer term data suggests that foreign stocks can offer real portfolio benefits in terms of risk reduction. Over the past 45 years, foreign stock returns have been much closer to their American counterparts. In fact, the CAPE measure indicates a substantial disparity between the valuation level of the S&P 500 and that of major foreign equity markets.
Research Affiliates has calculated CAPE for both foreign developed and emerging markets. The divergence between U.S. and foreign markets is stark as the following table illustrates. Of course, foreign equity indices are much newer than the S&P 500. Their statistical weight is lighter. Nevertheless, the data does suggest foreign stocks have more room to grow.
Source: Research Affiliates
Even a face value assessment of Shiller's P/E model does not sound an alarm. It's merely forecasting sub par stock market returns. Currently, Shiller's CAPE predicts that the ten year return on the S&P 500 will be range from 0.5 to 1.0% after adjusting for inflation. Siegel's version is more optimistic. These are sub par forecasts but still suggest better prospective returns than bonds. The 10 year Treasury Inflation-Protected security (TIPS) today offers a real yield of 0.4%.
It's unlikely that any single tool can reliably predict stock market returns. The drivers of financial prices are just too varied and complex. Most, if not all, information relevant to stock prices is rapidly factored into the market. Financial markets are capable of dramatic selloffs. It's natural to think they are attributable to some fundamental explanation, often with a conspiratorial flavor.
The truth is that stock markets have considerable underlying volatility. Basic statistical inference says that if you hold stocks long enough, you'll have a couple years with selloffs of 20% or more. That's just the law of averages in action.
Disclosure: I am/we are long SPY VEU TIP.
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.