CAPE of good hope

A powerful tool for investors to value markets

Cape of good hope

So yes, this is the CAPE of good hope.

And I was lucky enough to get down there in 2016 to visit my son who was completing his medical studies in Cape Town Hospital. 

If you get the chance, do visit Cape Town. It’s an amazing place with wonderful wines and scenery. And their currency has fallen a lot in recent years, so it’s cheap to stay there now.

Just be sure to take advice on where you go. Not everywhere is safe.

Okay, so before this turns into a ‘travel blog’, let’s try to make this dull stuff interesting with a simple explanation of a powerful tool for investors. The CAPE.

So what is the CAPE?

Well, let’s start with the last bit first.

The P.E. part of C.A.P.E  stands for Price to Earnings ratio.

So, that’s the price (P) of a company share (or a whole market of them) divided by the earnings (E) produced by that share (or market)

Simples.

Now you might conclude that, at any given time, if the ‘P’ (relative to the ‘E’) is higher than usual then that share (or market) must be overpriced.

Unfortunately, it’s not quite that simple 😉

You see, company profits (aka Earnings) tend to bounce up and down a fair bit – from year to year.

And those earnings bounce around even more for companies operating in what we call ‘cyclical’ industries.

Think about house builders for example. 

They enjoy times of feast but also suffer from times of famine.

So, one way to get a better idea of the ‘fair value’ of a share (or market) is to ‘adjust’ (average in this case) the earnings of that company (or all companies in the market) over a reasonably long timescale – say 10 years – to take out the effect of the business cycles.

And that’s pretty much all there is to it.

Take the current market price and divide it by the average (inflation-adjusted) earnings over say 10 years and you’ve got yourself a CAPE – a Cyclically Adjusted – Price to Earnings ratio.

A number which offers us a clue as to whether markets are wildly over (or under) priced.

It’s not perfect of course  – and, for goodness sake don’t use it (or anything else) for ‘day trading’ the markets.

That’s a very dangerous game – as we saw here

Money Mistakes

But the CAPE can offer us better information on longer-term trends than a single year PE.

Okay, so is this just the latest fad investment idea?

Not a bit of it.

A couple of smart guys (Benjamin Graham and David Dodd) came up with the idea in 1934!

Then another smart guy (Nobel Prize-winning, Professor Robert Shiller of Yale University) took their idea and gathered in the data for the US stock market, all the way back to 1880.

What’s more, Shiller makes his data available for free online at www.econ.yale.edu/~shiller/data.htm

So, I’ve simply used that data to explore whether the US stock-market is cheap or expensive right now.

And here’s a recent chart.

I don’t know about you… but it looks a ‘tad’ expensive to me 🙂

Shiller CAPE

So is the CAPE a perfect predictor of future returns?

Well, no, it’s not perfect – and just remember… there is no such thing as the perfect market predictor. So run a mile from anyone who tells you there is.

It’s quite clear from that picture above that the CAPE ratio has moved across very long ranges over time – from around 5 to 45

(although I think we might agree that 1999 looks like a ‘one off’)

So, whilst for much of the time (in the mid ranges) the CAPE offers few clues at all, it can be helpful to identify times (as now) when we’re in an extreme valuation Zone  – either high or low – by historical standards.

These are clearly times of heightened risk or (when the CAPE is low)  – opportunity.

What I find funny (or rather sad) is how the CAPE indicator loses its friends in the investment industry when it offers warning signals that might slow down the sales of investment funds.

And this is what’s been happening in the ‘chatter’ among so-called investment experts  – on the sell side of the industry – for some time now.

The simple truth is, as Andrew Van Sickle wrote in Money Week, that, 

“Whenever the Cape is high, strategists come up with all sorts of explanations for why a higher Cape is potentially justified, and thus perhaps not necessarily a sign of poor long-term returns”

These ‘eternal optimists’ will grab at any story they can find  – to support their ‘investment sales’ story.

They might tell you that it’s okay for CAPE to be where it is now because :

‘of a structural change in corporate profitability’ or

Globalisation has boosted the reach and earnings power of US companies’ or 

‘the reduced volatility in various economic indicators – make it okay for the CAPE to be up at around twice it’s more ‘normal’ long term average’

I have to say I’m not convinced by these arguments  – are you?

I mean just look at this picture – of the 25 year moving average of the CAPE over time. We’re now sitting up at a very exposed place if they’re wrong.

CAPE 10 25 year average

And as the guys from Research Affiliates point out here, there’s really no good reason to believe that company profits have moved up onto a permanently higher platea

They remind us that company profit margins and earnings as a share of GDP revert to the mean and they’re “sceptical that earnings can grow much in the years ahead, relative to GDP, without causing a populist backlash”

I agree – and you might argue that it was only due to a twist of fate that the US electorate turned ‘far right’ in their last election.

Next time, they could very well rush to support the far left – with all that implies for corporate profitability.

Jeremy Corbyn is certainly working on the assumption that he can pull off the swing in that direction over here.

Okay, well let’s just use another indicator

This is the other classic trick played by the ‘sell side’ of the fund industry.

If CAPE doesn’t help them – as now – they just turn to look at other indicators  – that don’t look ‘quite’ as frothy.

The trouble with most other indicators is that they don’t smooth out company earnings – so they’re simply a snapshot in time.

Or, worse, they’re based on the, invariably optimistic, forward projections of earnings from analysts.

Look, any price to earnings ratio – including those that ‘smooth out’ earnings over a period – is imperfect.

By choosing the length of the period over which to smooth – which happens to be ten years in the case of the Shiller CAPE – the numbers are still affected by the history of earnings fluctuations during that period. And yes, in the last ten years we saw the very worst of crashes in profits. So, some of the optimists might question whether this most recent ten-year period is a representative sample.

But whilst real earnings, as measured by Prof Shiller, did fall by c. 90% from the summer of 2007 (the greatest fall over such a short period in all the data back to 1871) this only tells half the story. There’s been a truly remarkable bounce-back in company profits over the last few years  – and it’s bigger than the profits crash in 2008-09.

So, yes, there have been some incredibly big shifts in company earnings over the last ten years, but they’ve been both up and down.

And that’s precisely why using ‘average’ company earnings over a decent period makes more sense than taking a snapshot of a single year.

We need to see the big picture for proper perspective.

Stockmarket prices vs Earnings

I’m in line with the folk at Money Week on this, when I say that the CAPE measure remains a useful one.

At the time of writing, it suggests stocks (in the USA at least) are overpriced… and, when you look at this next picture, you can see quite clearly how (in the past at least) future returns have been broadly (and negatively) correlated to the CAPE starting point.

Shiller CAPE with numbers

Listen to Robert Shiller

To quote Shiller himself on the potential ‘averaging’ errors – in his own measure (FT 2013)

… I’m a behavioural finance type, and I understand that people make all kinds of investing errors.

In a purely public spirit, I want to make it simple and easy. Ten years is very simple.

I would have preferred to make it an exponentially weighted moving average but we tried that and it didn’t seem to make any difference.

You also have something that’s easy to explain.

And here is Shiller again – from a debate in May 2017

“Stocks have generally outperformed other investments through history.

They are highly priced now, which means I don’t expect them to outperform so much.

But for a long term investor… there should be a place for stocks in a portfolio. . . 

. . . they could go up a lot . . .

. . . but they could also go down a lot”

You won’t get a clearer message than that 🙂

More interestingly his prediction (as of May 2017) over the long term (10+ years) is for the US Stock Market to return just 1% p.a. real (above inflation) returns.

So, after normal charges on most portfolios that would mean that you’d enjoy zero or less real returns.

Now that’s really not an exciting prospect, is it?

Especially when you consider that simple cash deposits have produced similar (inflation matching) returns over the long term – and they don’t ‘wobble’ in value.

More criticisms of the CAPE

Some pundits argue that we shouldn’t use a measure that, because of differing tax rates over the years, has delivered different after-tax returns to investors.

What matters, they say, are the after-tax returns.

This is a reasonable challenge. And thanks to John Authers (Financial Times, February 2010), we learn that Alain Bokobza (an analyst from investment bank Société Générale) undertook the grisly task of ‘normalising’ the data for varying corporate tax rates over the period.

Those tax rates rose from 12% before 1932 to 35% in 2010, with a peak of 50% in the 1960s.

And to normalise the earnings across the period he increased the tax rate in the low tax/early years and reduced it in the high years.

Those adjustments apparently give slightly less deep troughs in the CAPE, at about 6.5 for 1932, 9.9 in 1982 and 13.3 (close to the actual low) in 2009.

Anyway, at the current CAPE of 30, we’re a long way above any average… however you try to ‘tweak it’ for long term consistency.

Valuations change quickly and may be out of date when you read this BLOG.

So look up the latest numbers.

Other critics of CAPE say there’s no point in using historic earnings data – it’s the future that matters for where stock prices will settle.

And that’s quite true, but no one knows the future, do they? 😉

Analyst forecasts are very often wrong (by a lot) and over-optimistic, which makes them quite useless at a danger point.

At least we can see the past, it’s real and in this case, we’ve got the data over a very long period.

Another criticism of the CAPE is around what to use as a reasonable average. In other words, where should we say the normal range should be?

And that’s tricky to answer because the average is simply a function of the period over which you measure it.

Take the average over the 1990s and it would be a lot higher than the longer-term average.

Some argue that it’s valid to ‘lift’ the CAPE average now because the companies that make up the US stock market are different to twenty years ago. There are lots more high tech stocks which, have tended to trade on higher multiples.

The counter to that is whether the likes of the FANG stocks (Facebook, Amazon, Netflix, Google) will continue to justify trading on significantly higher multiples by continuing their meteoric growth rates long into the future?

I have my doubts – but if you like that argument you might like to adjust your CAPE – according to the ‘sector’ weightings of the stock market in question.

Indeed, this is precisely what the guys at Star Capital produced here and they still found the US stock-market to be overpriced.

The bottom line here is this:

The CAPE is not a perfect market predictor because no such thing exists.

But it’s certainly a useful indicator of value – for those prepared to take the long view on investing.

It can help us see when stock markets might have gone haywire, when valuations are at wackily cheap or expensive levels, relative to long-term history.

Yes, it’s rough and ready and it doesn’t promise any precision.

So, it’s a lot more honest than using a normal distribution model  – or other devious means to mislead investors about risk.

More on the problem with the ‘normal model’ here and here

And more on the ‘missing the best days’ trick that a lot of advisers use right here

What we can say for sure is that the CAPE value model is more useful than simply saying that markets are fairly priced at all times.

‘The Price is Right’ was a fun family TV game with Bruce Forsyth… and should not be used as an excuse for heavily exposing people to stock markets regardless of the climate.

We know why some advisers (those wedded to constructing their own investment portfolios) find it difficult to develop an investment advice process that takes account of bubbles and crashes.

In short, to do so could be very difficult to manage and to communicate.

So they tend to stick with broadly ‘static’ asset allocations for a given client’s risk profile, regardless of market valuations … and you need to bear this in mind when you engage an investment adviser.

If you’ve not tested your adviser on this ‘risk’ stuff yet – I suggest that right now is the time to do so.

Let me know how you get on – in the comments here

Thanks for dropping in,

Paul

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