Bears often cite misleading indicators
There are countless articles written in financial press on here and elsewhere that are essentially stock market bears citing various valuation metrics as proof the stock market is currently in a bubble.
The Buffett Indicator
First, many bears cite the Buffett Indicator. The most recent reading of the ratio of the US market cap to GDP is 132.2%, which compares unfavorably against the long term average of about 73% going back to 1960. As I've written about in detail previously, this indicator is fatally flawed because it is not performing a like-to-like comparison. The numerator, US market cap, reflects earnings power throughout the world, but the GDP used in the denominator is only US GDP. However, over recent decades, global GDP growth has outpaced US GDP, so naturally earnings power of US companies was able to grow faster than US GDP in a sustainable fashion since the former reflects faster growing global GDP, while the latter reflects the more modest US GDP growth in recent decades.
General time series analysis principles suggest that comparisons to long-term means are only relevant to the extent that one doesn't expect the mean to change over time. Due to changes in the composition of US earnings over time, and the fact that it is not reflected in US GDP, the Buffett Indicator naturally would have a change in the mean over time, so comparisons to long-term averages are highly distortive.
The Shiller PE
Another popular metric cited by bears is the Shiller PE. The current reading is 33.4 as of the close on February 2, 2018. This compares unfavorably against the long term average of 16.8. Some analysis of regressions suggests that the implied future annual return is negative 3.3%.
Once again, the Shiller PE has a significant flaw that makes performing time series analysis extremely misleading. The Shiller PE adjusts 10 years of earnings for inflation using the CPI, and then takes an average to get the earnings figure to be used in the denominator, with price as the numerator, to get a CAPE figure. The main issue is that buybacks rose to prominence after the 1982 safe harbor by the SEC. They have become particularly prominent in the 21st century, in lieu of dividends, and buybacks allow a permanent reduction of shares that allows earnings to grow faster than inflation indefinitely. Therefore, a mere CPI adjustment is not enough of an adjustment in the CAPE calculation.
Another major issue with the Shiller PE is that the nature of the CPI has changed over time with changes like the substitution effect, which most economists agree led to lower CPI readings in recent decades.
Naturally, if CPI-based earnings adjustments are understating present earnings power more than in the past, comparing current Shiller PE readings to historical ones is very problematic. But the bears continue to use the comparison, although I have warned in depth about not using the Shiller PE.
My point that the Shiller PE comparisons to historical averages overstates the market valuation and understates future returns is supported by the graphic below.
As one can see, since the 1980s, the actual returns have been exceeding the expected returns consistently, with the gap widening in current years. Time series analysis principles suggest the errors of a prediction should be independent and identically distributed, meaning mostly random. But we can see here, that for periods before the mid 1980s, the Shiller PE overstated actual returns, but after 1985, it understated returns. This suggests a fundamental shift in the expected average Shiller PE in the two time periods, so using the entire period as an average appears very inappropriate. I hypothesize that the inability of the Shiller PE to adjust for buybacks and changes in CPI are most of the reason for disparity, although changes in interest rates may also be a factor.
S&P Price Regression Trendline
The final misleading indicator bears cling to is the S&P price regression trendline. I've written about this in detail a month ago. Essentially, the issue here is that the S&P price should be expected to have risen faster in recent years than its very long term average, since buybacks have been favored in recent years as the means of capital returns in lieu of dividends. As a result, more of the returns would come in the form of capital appreciation, and the faster pace of price rises should not be unexpected. Also, comparisons to periods before 1940 appear to hurt the relevancy, since before 1940, there was never really consistent positive price inflation. However, after 1940, there has been positive price inflation, so naturally, the S&P would have to rise faster in recent years to maintain the same real, inflation-adjusted return.
Many bears have cited the Buffett Indicator, Shiller PE, and S&P Price Regression Trendline as proof that the stock market is in a bubble. All three of these metrics have very serious issues that distort the comparisons, and violate basic principles of sound time-series analysis.
Since the analysis derived from these metrics is seriously flawed, it is no surprise that the conclusions of those using these metrics have generally been wrong for a long time.
The Buffett Indicator has been above its long term average of 73% for nearly all of the last 23 years except briefly after the Dotcom crash and 2008-9 crash and financial crisis. The Shiller PE has the same story with it only being below its long term average for a brief period in 2009. Finally, the S&P price regression trendline also only signaled favorable valuations once, briefly in 2009, in the last 23 years.
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I welcome all comments below, even if extremely critical, since this piece is highly critical of various metrics used by market analysts, it would only make sense there is naturally counter-criticism.
Additional Disclosure: The information contained in this article is an opinion and constitutes neither actionable investment advice nor a recommendation to trade any security.
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.