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.



** The Shiller CAPE Ratio: A New Look
Jeremy Siegel - Financial Analysts Journal - 2016


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