What if CAPE is not overvalued?

I would like to preface this post by saying I do generally fall on the side of their being a recession in the next few years and that the manipulation by the central banks of the world has made markets much more perilous over the last decade.

With that said I thought it interesting to point out that the CAPE ratio that is generally used as a clear indication of frothy markets may not be as overvalues as it appears. At current writing, the Shiller PE is at 28.60 (http://www.multpl.com/shiller-pe/) which is often talked about as being well above its historical average and indicative of poor future stock returns. I would implore everyone who uses this measure to review the CFA Publication written by economist Jeremy Siegel as to why the CAPE ratio may not be as overvalued as it appears.

Seigel points to a few key drivers of the CAPE ratio that have cause distortion in the metric and could potentially be distorting the value. Namely, these items are:

1. Dividend Policy
2. Earnings Accounting Standard changes set out by FASB
3. Aggregation Biases in the S&P earnings numbers through 2008 crash
4. Composition of S&P 500 constituents over the last number of years

Interestingly when one takes into account the above items and adjusts the CAPE ratio for these potential distortions Seigel lands on a Shiller PE (or should I say Seigel PE) of 17.28 with a mean of 16.14 as of January 2015. this implies a slight overvaluation of 7% and a long run return for stocks of 5.25%. This measure also retains the same explanatory power (R-Square) as the original measure the CAPE ratio.

What this means from an investment point of view is hard to discern as there are obviously many exogenous factors that need to be accounted for when deciding on the risk reward for stocks moving forward, but I believe it is important to take note, review and delve deeper into the drivers of some of the metrics that we all use and sometimes take at face value.

I would like to hear everyone else opinion on this and any comments or critiques of the information. Link to the full publication is below.

Best,

Matt

** The Shiller CAPE Ratio: A New Look
Jeremy Siegel - Financial Analysts Journal - 2016
http://www.cfapubs.org/doi/pdf/10.2469/faj.v72.n3.1

Comments

  • Hi Matt,

    you might check out this link:
    https://www.hussmanfunds.com/rsi/cape.htm

    Thanks

    Christoph
  • Hi Matt and Christoph,

    You cannot believe how I am feeling finding this thread! I came to the forum expecting to write a similar post to Matt. I also feel that we are dealing with overvalued market conditions and generally unstable times, but I also want to seek out as much contrarian views to my own so that I can be challenged as much as possible! I recently came across this interview with Ray Dalio that set me on the information hunt for more respectable people of feel the market is not as overvalued as many of us do.



    One of the difficulties that this information presents is how to look at intrinsic value or run a discounted cash flow analysis if these more recent PE ratios are to be a new norm for the next few years at least. Another way to ask this is, 'if we are only slightly over valued then how do we better evaluate the relative values of individual picks?' I have little more to add right now in terms of analysis, but I do appreciate the opinions and information you shared!
  • Hi Cory,

    I did not have the possibility to watch the video yet- I will do so soon.
    But I had already recently read that Ray Dalio has a rather positive view in the short-term and considers stocks not extremely overvalued.
    I personally have no opinion on the short-term. I only work long-term - and here I am just absolutely certain that stocks are wildly overvalued.
    You can reasonably argue that the CAPE is no longer valid today (although I disagree). But even if this is true -
    then also all other historically reliable indicators (e.g. nonfinancial market cap/Gross Value Added, etc. ) show a very expensive market.
    So no matter how you look at it - long-term the market is extremely expensive and will crash by about 50% sooner or later.

    Thanks

    Christoph

    P.S.: In case you click on the link to my blog shown below - it currently does not work. Seems to be an issue with the provider, but should soon be back on. Just in case you wonder.

  • @christoph . How you know that the market will crash by 50%? why not -20%? I would be worried if I hold a US or Danish indexfund (overvalued countries) but not holding individual stocks thats below intrinsic value.
  • HI @Ecofreedom,
    of course I do not know for sure, how much the market will crash. But the logic behind 50% is this:
    Throughout history the market has so far always eventually reverted to the mean. Indeed, most of the time the market even got cheaper than that.
    And the historically mean price of stocks is about 50% of current prizes (for US stocks even a little more than 50% probably).

    So if we do not have a 50% crash, it would be a complete historic novelty.

    Thanks

    Christoph
  • @christoph. Yes but that 50% crash might not even happen this year or for the next 3-5 years. You said you sold all your stocks; did you sell them because they where overvalued (above I.V)? or you just sold because you expect a 50% crash to make a drawdown on all stocks. If you sold them on the reason that you think the market will crash in the near future I disagree with this being a good strategy
  • Hi Eco,
    As a full-cycle investor i sell when it gets too expensive. So when you ask,if i soldbecause of an expected 50% crash or because the intrinsic value was too high-that is the same thing.

    Charlie Munger once said:"We always look for good opportunities. If we dont find any,we wait."
    While i am not good in short-term predictions,i still make one here:I expect the crash of 50% to start untl the end of 2018 at the latest.
  • edited June 9
    @Matt_Soda

    For a contrarian view I think you need to leave the narrow perspective of the value investor community - for all of its strength, much of the information and key personalities are read by everyone and therefore the wisdom of the crowd mentality can set in. Equally, the community tends to draw its 'Day One' view from either somewhere in the pre-1930's data or at the earliest the 1870's; this is obviously because of availability of data and not shortsightedness but it is a small snapshot in time of the full history of economics and markets.

    My advice would be to read recent books such as Gordon's 'The rise and fall of American growth' or Tyler Cowen's 'The complacent Class' or 'Makers and Takers: The Rise of Finance and the Fall of American Business' by Rana Foroohar.

    I would also read Niall Ferguson's 'The Ascent of Money'.

    A general theme being that global growth was flat for more than 1000 years until the industrial revolution and that most of those advances that have been truly transformative (electricity, flushing toilets, air travel) have now been largely exhausted and that growth now is in periphery advancements that are not truly transformative nor are they really contributing to actual growth; that most of the new growth is not found in services of innovations that we would absolutely not want to be without.

    I'm not endorsing those views, merely putting forward what I would consider a good place to find a truly contrarian viewpoint absent any groupthink, confirmation biases or anchoring biases. Plus they are also really interesting points just to think about!!
  • @Matt_Soda

    Bill Gross actually referenced the Gordon thesis of growth today on Bloomberg: https://www.facebook.com/bloombergmarkets/videos/vb.154758931259107/1298112753590380/?type=2&theater

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