Robert Shiller is the doyen of doom and gloom in the financial markets.
He’s called nine of the last three crashes in stocks, bonds and property(!). And he even won a Nobel Prize for his efforts in 2013.
Shiller came up with a new way to measure whether the stock market as a whole is expensive or cheap – it’s called the cyclically adjusted price to earnings ratio, or CAPE for short.
CAPE tries to show investors whether or not it’s a good time to be invested in the stock market, by showing whether the market is cheap or expensive relative to the long run historical trend.
It shows the market’s current price divided by an average of ten years of earnings. The idea is that by taking a longer-term view of earnings, you cancel out the market’s boom-and-bust cycle which gives you a truer picture of fair value than the price/earnings ratio from a particular moment in time.
Over the long run, the CAPE ratio has averaged about 17. And today it’s 25. That seems to show that stocks are expensive right now.
Perhaps for that reason, the CAPE ratio is a favourite of doom-mongers, worriers, and stock market pessimists the world over. It’s often presented as evidence of an impending crash.
Robert Shiller himself expects the market to correct itself sooner or later, and head back to the long term average. Last week, he warned that the market is due a correction. (He’s been making such warnings for many years.)
I think you need to be very careful with the CAPE ratio though. It overstates how “expensive” the market really is. And it doesn’t provide a true apples-to-apples comparison over time, which is the very point of it.
So here they are: four reasons why CAPE is not going back to 17 any time soon.
Be careful with CAPE
- In the past, when companies wanted to give money back to shareholders they paid a dividend. But today, they give roughly half the money back as dividends and half back as share repurchases. Share repurchases have the effect of increasing the value of stocks. This by itself will add a couple of points to the CAPE ratio.
- It’s cheaper to invest now. Transaction costs are lower than they used to be, and it’s much cheaper to access information. This feeds through to returns, and CAPE. If the cost of investing in stocks falls because of smaller transaction costs etc, investors will get the same returns for a higher stock price. So if the costs of investing were to fall by .5%, that would be enough to increase cape from 20 to 22 with the same returns for investors.
- Returns from other assets like bonds are very low by historical standards. This feeds into stock prices: the lower returns from other assets (ie, interest rates), the more investors will be willing to pay for stocks. And the higher the CAPE ratio will go.
- Accountants now count profits differently in a few different ways. For example, “goodwill” is now treated more harshly on company accounts than it was in the past. Again, pushes up the CAPE ratio.
The whole idea of CAPE is that you look across a long period of time to get a better picture of fair value. But the problem with comparing things over a long period of time is that over a long period of time, things change a lot! It’s not possible to hold everything else constant and just measure the one thing you’re looking for – in this case, the price investors are willing to pay for a company’s earnings.
That makes an apples-to-apples comparison difficult. And in the case of the CAPE ratio, I would argue that it makes it impossible.