Why The Shiller CAPE Ratio Is Misleading Right Now

Summary

• Robert Shiller's Cyclically Adjusted Price to Earnings (CAPE) ratio is now around the level of 1929, and it was only higher in the late 90s dot-com bubble.
• Many commentators have pointed to this indicator recently as a danger sign for the stock market.
• However, this is misleading right now because the CAPE ratio's 10-year back period begins with the Great Recession in 2007.
• So the 10-year earnings are abnormally low, due to the effect of 2007-2009 on the 10-year average.
• As the recession years "roll off" the 10-year back period, the 10-year average earnings will increase, and stock prices can rise without making the Shiller CAPE ratio rise excessively.

Last week many commentators were talking about Robert Shiller's Cyclically Adjusted Price to Earnings (CAPE) ratio: It is now at 29.66, around its peak level in 1929 before the Black Tuesday crash. The ratio was only ever higher in the late 90s dot-com bubble.

(Source: multpl.com)

Therefore, many people right now see this indicator as a big danger sign for the stock market (SPDR S&P 500 ETF (NYSEARCA:SPY), PowerShares QQQ Trust (QQQ)).

Of course, it is understandable to be concerned about valuations and earnings when buying stocks. But we should also look at all the factors and variables that go into the Shiller CAPE ratio, as well as other macroeconomic factors that affect stock prices today, before we jump to conclusions.

Low Interest Rates and Central Bank Actions

A couple important factors that justify a higher CAPE ratio have been frequently cited in recent years. First of all, extremely low interest rates: When it is so difficult to earn any significant return on one's capital in the money market or the bond market (iShares 20+ Year Treasury Bond ETF (TLT)), investors will tolerate lower expected returns on stocks as an alternative -- because they're still better than bonds -- driving stock prices and P/E ratios higher. To put the 100+ year Shiller CAPE ratio chart in perspective, one should also look at the 100+ year history of the 10-year U.S. Treasury bond (iShares 7-10 Year Treasury Bond ETF (IEF)) yield:

In recent years, we have seen this dynamic have a very specific material effect on the S&P 500 index in particular: During periods when higher-risk growth sectors have sold off, many investors have shifted funds into lower-risk stock sectors such as utilities and consumer staples, rather than shift those funds into low-yielding bonds. Since utilities and consumer staples are still part of the S&P 500, this has softened the effect of stock selloffs on the index. I believe this is one big reason why the global market decline of 2014-early 2016, which was really a bear market, only resulted in a 15% decline in the S&P 500.

The other big factor that is often cited, and correctly so, is the increasing role of the world's central banks in propping up global stock markets. In addition to setting low interest rates, the Bank of Japan has gone so far as to buy a large portion of the shares in the entire Japanese stock market itself. When central banks are willing and able to take such actions, one can only expect that stock prices and P/E ratios will be higher than they were in past periods.

Now of course one can argue that in the long run, such actions by the world's central banks will not be sustainable. But we should understand that this argument is really predicting a central bank collapse, not a stock market collapse. And it is very difficult to be able to predict in advance whether the proper timeline for such an event is to be measured in months, in years, or in decades. In the meantime, before such a central bank collapse, we can expect average stock market P/E ratios to stay at higher levels than they did in the past.

2007-2017 Is A Misleading Period To Measure Average Earnings

These are familiar arguments among financial analysts and commentators. In this article, I want to address an additional factor that I see as having a big and misleading effect on the value of the Shiller CAPE ratio right now: The particular 10-year back period for which the ratio is counting earnings at this time.

It so happens that 10 years ago was the summer of 2007, right around the time that the Great Recession began.

So the 10-year period of 2007-2017 happens to be a historically bad period for earnings. First you have the recession itself from 2007 to 2009. Then you have the slow recovery, from a very low level, over the following years -- and even that included some very shaky times such as 2011, which was also really a bear market for just about everything in the world except the S&P 500.

Then, more recently, you had weak earnings in many sectors in the 2014-2016 period. That includes the oil price collapse, which devastated the earnings of the entire energy sector, a big part of the S&P 500. It also includes the market downturn of 2015-early 2016, when weak earnings across the board made it very common to refer to an "earnings recession" at the time.

CAPE, like any price to earnings measure, is a ratio: It is calculated as stock prices divided by 10-year average earnings. Thus you can get a very high CAPE value not only because of very high stock prices, but also because of very low average earnings. And that is precisely what we have for this particular 10-year period from 2007-2017.

If we measured CAPE with a 12-year average earnings period, or an 8-year average earnings period, it would not look so historically high as it does right now with a 10-year period. The 12-year period would include the better years in 2005 and 2006, and the 8-year period would not include the depths of the Great Recession in 2007-2009.

1919-1929 and 1989-1999 Were Not Like 2007-2017

Contrast this to the previous extreme highs of the CAPE ratio in 1929 and the late 1990s. In 1929, the 10-year period was mostly the Roaring 20s, an economic boom time with high growth and high earnings. Unlike today, the CAPE ratio back then was very high because of very high stock prices, not very low average earnings.

Similarly, in the late 1990s, the 10-year back period was a relatively good one for the economy and for earnings. Yes, there was the recession in the early 1990s. But it wasn't nearly as severe as the Great Recession in 2007-2009. And the strong economy of the late 90s more than made up for it, in terms of the company earnings that it produced. So again, the CAPE ratio was very high in the late 90s because of very high stock prices, not very low average earnings.

Forward Outlook On Earnings And Stock Prices

The point is, if earnings continue to rise going forward as they have in the past year, they will now be replacing the recession years in the calculation of the 10-year average earnings that the Shiller CAPE ratio uses. This dynamic will significantly increase the 10-year average earnings, the denominator of the CAPE ratio. This in itself will tend to bring the value of the Shiller CAPE ratio down.

So stock prices can continue to rise, without dramatically affecting the value of the CAPE ratio. Now I would not be surprised to see stock prices rise so high that the CAPE ratio does go higher, even despite the modifying effect of higher 10-year average earnings in the ratio. But the point is that the CAPE ratio can rise much more slowly and modestly than it did in the late 90s, even if stock prices boom over the next year or two.

It is perfectly fair to be concerned about stock price valuations, and after another year or two there may be genuinely greater cause for concern. But simply pointing to the Shiller CAPE ratio right now, and then to 1929 and 1999, is not a valid argument in itself. The 10-year periods that the CAPE ratio measured back then were very different than the 10-year period that it is measuring right now.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

I am long various tech stocks and other stocks.