By
John Overstreet
:
Please, don't get me wrong: I love P/E ratios. Click on my past
articles, and you would be hardpressed to find one that did not
put P/E front and center in discussions about inflation,
commodities, bonds, geopolitics, you name it. Why I have finally
turned on Shiller's P/E10, the Cyclically Adjusted P/E ratio ((
CAPE
)), is simply because a) it adds virtually no value to other
measures of P/E, b) the way it has been constructed and applied is
highly problematic, and c) it is only effective under a strict set
of conditions.
I have talked plenty about why I thought that using trailing
twelvemonth earnings ((
TTM
)) or concurrent earnings and prices is superior to CAPE, but it
has taken me a long time to finally realize that CAPE is
fundamentally flawed, probably to the point where we might be
better off eliminating it altogether. That may be a bit harsh: a
ratio is just a ratio, and in any ratio you can find useful
information.
But, there is a lot of chatter about how stocks are overpriced
because of CAPE, and this is a misappropriation of an already
flawed measure.
So, what precisely are the problems?
Having talked about some of my issues with regard to Shiller's
use of CAPE in previous articles, in this one, I would like to
confront CAPE on its own ground.
In terms of construction, here are the problems with Shiller's
P/E10:
1. It is adjusted for inflation.
2. It is backwardlooking.
In terms of how it is applied,
1. It is generally compared to "real" returns rather than
nominal returns.
2. It does a poor job of predicting future returns.
3. That it has managed to predict any returns is a statistical
fluke.
Of course, some of these seem like either necessary evils or
outright positive features, particularly those involving the
construction of the ratio as well as the comparisons to "real"
returns. "Naturally," most readers will probably imagine, "you have
to adjust both the ratio and the compared returns for inflation.
Everybody knows that. And, of course, it's backwardlooking. That's
the whole point. We don't know what the future holds, and we use
the past to give us a rough guide of what a reasonable level of
earnings might be. And, what do you mean it does a poor job of
predicting returns? Everybody and their grandmother knows about the
relationship between CAPE and future returns."
That is a reasonable point of view, but those adjustments are
fatal flaws, not strengths, and the data don't say what people
think they say. Let me see if I can shake your confidence a little
on these points.
First, look at the chart below. This is a comparison of CAPE
with twentyyear annualized nominal returns and inflation. Shiller
used tenyear "real returns," of course, and that's the standard we
will use in the remainder of the article, but I want to raise some
doubts first.
(click to enlarge)
(Note: All data in this article are derived from
Robert Shiller's data
, unless otherwise stated).
Isn't it odd how well CAPE has predicted inflation? And, isn't
it odd how poorly it predicted returns prior to the late 1920s?
That means at least some portion of the negative correlation
between CAPE and subsequent returns is a function of CAPE's
historically consistent ability to forecast inflation (at least
until relatively recently). But, how on Earth did that come about?
Since when did CAPE predict inflation? With twenty years of high
CAPE ratios, are we due for decades of doubledigit inflation?
Well, I can't tell you what inflation will be like in the 2030s,
but I am fairly certain that CAPE is not forecasting imminent,
relentless inflation.
This is partly a real phenomenon and partly a fluke. Inflation
has consistently been inversely correlated with P/E ratios for the
last 140 years. That's for real. The fluke is that P/E ratios have
moved in Kondratiefflike, regular twentyyear waves, which can be
used to create the statistical impression that CAPE somehow
predicts inflation.
(click to enlarge)
(Source:
MeasuringValue.com
,
Stephan Pfaffenzeller
, Shiller, Roy Jastram's
The Golden Constant
)
If we are going to consider how CAPE relates to future returns,
we should at least consider looking at nominal and real returns
separately.
And, then there is the question of construction, particularly
whether or not calculation of CAPE should be adjusted for inflation
itself, since the stock index would tend to be negatively
correlated with inflation and earnings positively correlated, all
else being equal. The inverse correlation between P/E ratios and
inflation (and especially commodity prices) suggests that P/E
ratios either impact inflation or inflation impacts P/E ratios. If
it is the first scenario, then rising stocks reduce inflation. To
then include inflation as a factor in the returns is essentially
doublecounting and says nothing about the rationality or lack
thereof of investors. If it is the latter scenario, where inflation
is impacting P/E ratios, then Shiller's thesis about equity
valuations being governed by human emotion rather than economic
fundamentals is less certain.
Whatever the case may be, it is clear that the consistent,
inverse correlation between P/E ratios and inflation, as well as
the supercyclicality of P/E ratios makes comparisons between CAPE
and "real" returns problematic at best. Those alone are not grounds
to eliminate CAPE, but it makes it necessary to crossreference
nominal P/E measures and nominal returns with CAPE and "real"
returns to make sure we are not mixing apples and oranges.
The remainder of the article is going to amplify these themes by
digging deeper into the historical data using Shiller's data
segments, demonstrating why there is nothing magical at all about
CAPE and why its grip on the imagination of the market is a clear
and present danger. Built into these comparisons of
backwardlooking P/E measures with future returns are highly
questionable assumptions.
Before pushing ahead, readers should be sure that the problems
evident in that first chart are apparent, because those issues are
more or less the threads I am going to be pulling at from here on
out.
CAPE and Future Earnings
So, now consider a few more charts. The next one is a comparison
of CAPE, P/E TTM, and tenyear nominal returns. From the Depression
up until the Credit Crisis, these two measures of P/E were quite
tightly correlated. Prior to that, the relationship was much
weaker, not only between each other, but between each of them and
stock returns. It appears that P/E TTM had a tendency to be
positively correlated with returns in many instances.
(click to enlarge)
Why might that be? Forget P/E ratios for a second and think
about E/P, the earnings yield. Suppose the stock market was at 1000
and earnings fell from 100 to an unprecedented low of 50 while
stocks barely moved, or only move down to 950. That means the P/E
would move from 10 to 19. Are stocks overpriced or underpriced?
That depends on where earnings are going. If earnings bounce back
to 80, the yield on stocks will rise, and P/E will fall. In other
words, stock yields may tend to correlate with bond yields, but
stocks are not bonds. A very low yield may be a buying opportunity.
That's what we saw in 20082009, when the P/E TTM ratio shot up
into the triple digits. It simply depends on whether earnings mean
revert.
That may be a fairly obvious point, but when we combine this
simple problem with the other flaws, we get a poisonous brew.
Now forget all that for a moment and consider the following:
Shiller's examination of P/E ratios is not expressly designed for
predicting stock returns. It is simply that the inverse correlation
between P/Es and returns is believed to demonstrate his point about
investors being irrational.
The fundamental question is, do investors pay too much for
future earnings? One way to check that is to calculate P/Es using
forward earnings. In the chart below, I calculate the "P/E F10,"
which is the stock index divided by a moving average of the
subsequent tenyears' worth of earnings, and plot it beside CAPE
and returns.
(click to enlarge)
You can see that, like P/E TTM, it correlates quite well with
CAPE for long periods of time, especially after World War I. What
is really interesting is that it so strongly (negatively)
correlates with future returns, almost perfectly so, in fact.
So, a question we can consider is, since Shiller's fundamental
concern is whether or not investors pay too much for future
earnings, and we have found that this forwardlooking P/E ratio
(i.e., the P/E F10) is so strongly (negatively) correlated with
returns, does that not prove Shiller's thesis even better than
CAPE?
At first, I thought that was the case, but once I thought about
it again, I realized that it said nothing of the sort. After all,
what is the alternative? It is almost (but not quite) the same
thing to compare forwardlooking earnings with future returns. That
is to say, by definition, if you pay too much for future earnings,
your future returns will be weak.
(click to enlarge)
We will come back to that later. In the meantime, look at the
relative levels of CAPE and the P/E F10 before and after the Great
Depression in the chart prior to the one immediately above. After
the Depression, CAPE remains well above the P/E F10 throughout the
entire seventy yearspan. The reason is, quite simply, that
earnings growth has remained positive over decadal intervals,
growing, since the 1960s, at a fairly consistent 6% or so per
annum.
(click to enlarge)
Things get tricky here. Think about this for a moment. If
earnings grow at a relatively constant rate over decadelong
periods of time, then shouldn't that alter how we determine where
valuations stand relative to their historical averages? In other
words, if we are investing in a stock market where earnings are
highly variable, using historical earnings
may
be reasonable, but if we know that profits will now essentially be
guaranteed in the long run, using historical earnings would have us
consistently underpaying for future earnings, wouldn't it?
Is There A Difference Between Using Past Earnings and
Projected Earnings? Not Really
Plenty of smart, prudent people have ripped into analysts for
incorporating 2014 or 2015 earnings estimates into their outlooks
recently. I think I can only halfagree with that condemnation.
Over annual intervals, it seems pretty ridiculous to me to present
next year's earnings with a straight face this year. (Then again,
what do I know?) On the other hand, for sixty years now, over long
enough periods of time, we seem to have a virtual guarantee of 6%
earnings growth.
That inevitably raises the question, how reliable is that
growth? Is it more prudent to predict earnings for 2024 than 2014?
And one has to ask where the growth came from to begin with. It
doesn't seem that anybody has a good answer for this.
Let's step back again. The real question has always been how
much should we pay for future earnings. When we look at the numbers
from that point of view, it suggests that, since the Depression,
forwardlooking P/E ratios have fallen fairly steadily, while
backwardslooking ones like CAPE have tended to rise. If we project
median rates of earnings growth over the last 140 years onto the
next ten, it suggests that forwardlooking P/E ratios are about
right, although it is somewhat strange that those ratios have been
so stubbornly high over the last twenty years.
(click to enlarge)
(click to enlarge)
So, how ludicrous is it to calculate P/E ratios from tenyear
forecasted earnings based on nothing more than a blind historical
extrapolation? Wouldn't a backwardlooking ratio like CAPE be more
prudent? Isn't that what the question boils down to? Doesn't it
seem imprudent to count chickens before they've hatched?
It may seem like we are playing with fire by taking tenyear
forecasts of earnings seriously, but I have to point out that those
earnings forecasts are based on projecting historical performance
out into the future, and here's the rub:
the period in which earnings have consistently been
positive over decadelong intervals also happens to be
the only period in which CAPE did a good job of predicting
future returns.
In other words, there is a very strong correlation between
rising earnings and CAPE's ability to forecast returns. Why is
that? Perhaps it is obvious to others, but it was not obvious to me
at first:
there is virtually no difference between using a moving
average of the previous ten years' earnings as a proxy for normal
earnings and projecting the average historical rate of growth into
the future
. It changes the longterm absolute levels, but it does not change
the cyclicality, since the cyclicality for the last century has
come almost entirely from the stock index, not earnings.
To put it yet another way,
for people who may think that it is ridiculous to make
projections of future earnings growth based on historical earnings
growth, that is precisely what Shiller's CAPE does
. He certainly does not present it that way. When he presents the
correlation between CAPE and subsequent returns, he uses a
scatterplot for the entire post1871 market, which masks the
degree to which CAPE is dependent on stable earnings growth. When
you separate the steadygrowth scenarios from the unpredictable
growth scenarios, the problem becomes manifest.
(click to enlarge)
(click to enlarge)
To sum up, there is only a slight difference between using
past earnings and using forward earnings projections extrapolated
from historical growth
. If you use CAPE, this has a tendency to raise equity valuations
above longterm averages, but it is possible that the markets have
"known" that earnings are backstopped and have been willing to pay
accordingly, which is reflected in the gap between CAPE and the P/E
F10.
In any case, I have to reiterate that the
CAPE has really only managed to predict future returns when
earnings have risen over the long term
. Look at the following table. I have used a variety of P/E
measures, including not only those calculated from tenyear
trailing earnings, oneyear trailing earnings, and forward
earnings, but a tenyear centered moving average and a twentyyear
centered moving average. Smoothed out averages, particularly those,
which incorporate future earnings, do a better job of predicting
future returns.
P/E ratios 
Correlation w/ real returns 
Correlation w/ nominal returns 
over/under historical average 
Last period for under/over 
CAPE 
0.45 
0.47 
+53% 
Dec '13 
P/E 10* 
0.35 
0.31 
+52% 
Dec '13 
P/E 
0.37 
0.40 
+15% 
Sept '13 
P/E TTM 
0.37 
0.40 
+20% 
Dec '13 
P/E TTM* 
0.37 
0.39 
+17% 
Dec '13 
P/E F10 
0.59

0.66

+38% 
Dec '13 (est) 
P/E F10* 
0.43 
0.68

+25% 
Dec '13 (est) 
P/E C10 
0.49

0.53 
n/a 
Dec '03 
P/E C10* 
0.45 
0.53 
n/a 
Dec '03 
P/E C20 
0.54

0.59

n/a 
Dec '03 
P/E C20* 
0.45 
0.57 
n/a 
Dec '03 
(The asterisks refer to P/E measures calculated from nominal
values).
In the chart below, you can see how the increasingly
negative 50year rolling correlations between P/E measures
and subsequent returns have strengthened when earnings have
strengthened and weakened when earnings have weakened
.
(click to enlarge)
Using tenyear rolling correlations produces much the same effect.
CAPE is no better at predicting future returns than other
measures, since its effectiveness is contingent upon a constant
growth in earnings
.
(click to enlarge)
(click to enlarge)
That leaves CAPE with two fundamental, interrelated
weaknesses:
a) it effectively assumes a positive rate of earnings growth
(masked as a moving average), leaving it exposed in a market where
earnings are volatileand having assumed that positive rate of
growth,
b) it nevertheless routinely overestimates the amount the market
is valuing equities by using backwardslooking earnings.
It's the worst of both worlds.
The Problem of Supercycles
That is not all. All of these ratios suffer from another fatal
flaw when used as predictors of tenyear returns. They all depend
on the supercyclicality of the market. If you look back at the
chart near the beginning of the article that shows CAPE
"predicting" the level of inflation, you will see that both
inflation and returns have deviated from the cycle. In the rolling
correlations above, we can also see that these (negative)
correlations between P/E ratios and returns appear to be weakening
over the last twenty to thirty years.
Part of that is due to the increased volatility of earnings, but
part of that is also due to an upward bias in stock valuations over
the same period of time.
Stocks are moving up higher and for longer periods of time,
which is breaking the regularity of the old Kondratieff cycle in
markets and undermining the oncereliable link between P/Es and
returns
.
Before considering this latest variation on trends in stocks and
earnings further, let's take stock again of where we are:
1.
It is, at best, problematic to use inflationadjusted ratios or
returns
. It is probably not fatal to do so, but it is anachronistic and
unnecessary, and to do so prejudicially rejects the possibility
that P/E ratios are driven by fundamentals rather than emotion.
2. Using P/E ratios to estimate multiyear returns depends on
one's ability to predict earnings over that same period.
The notion that CAPE has any ability to predict future returns
rests on the idea that future earnings will look like past
earnings
. The only difference between this and projecting earnings into the
future is in the absolute level of P/E ratios. It only varies the
degree to which stocks are made to appear over or undervalued.
3.
Using P/Es to predict future returns depends not only on an
accurate prediction of future earnings but on the consistency of
the supercycles
. The dramatic expansion of P/E multiples in the late 1990s, the
relatively high levels that were maintained during the 2000s, and
the relentless rise in P/E ratios since 2011 all seem to point to a
break in that once reliable cyclicality.
CAPE is completely dependent on these factors. Without regular
supercycles and without relatively predictable earnings, the
ability of CAPE to 'telegraph' future returns is approximately
zilch!
As I said, the regularity of supercycles has apparently broken
down since the mid1990s. That is reflected in virtually every
chart we have examined so far.
The Earnings Conundrum
No matter which measure we use, we are therefore forced to come
to grips with the "problem" of constant earnings growth. To repeat,
if an analyst insists on using backwardlooking ratios like CAPE to
forecast future returns with the handydandy correlations that
Shiller used and analysts continue to use today,
he/she is already taking it for granted that future earnings
growth will approximate past earnings growth
. But, if that is the case, why not just project that growth
outright?
Why hide behind CAPE?
I am not saying it is intellectually dishonest to use CAPE.
Rather, I would say it is intellectually selfdeception.
It is speculation with a veneer of historical
studiousness.
If we do project something like 56% earnings growth over the
next ten years, then P/E ratios are not nearly as expensive as CAPE
suggests. But, once the implicit assumption of earnings growth
within CAPE is brought out from the shadows, how many analysts
really feel comfortable predicting earnings over the next decade?
Do people seriously attempt this? Perhaps someone does somewhere,
but really, all I see and hear are arguments over whether we should
use CAPE, TTM, or shortterm earnings forecasts, a discussion that
is useful only if you know how to use each ratio.
Why have earnings grown so consistently since the 1930s and
especially since the middle of the last century? Could it have
anything to do with the profound revolutions we have experienced in
monetary matters since 1914? Or are there endogenous forces within
the real economy having this profound impact? If it is due to
political and institutional factors (e.g., the establishment of a
central bank and the transition to a fiat currency system), is
there any reason to think that the backstopping of profits will not
be sustainable over the next decade? If the rise in profits has
been natural rather than artificial, can we expect that cause to
continue to work its magic in the 2010s and 2020s?
(click to enlarge)
As far as I know, nobody knows the answers to those questions,
but if investors, after careful consideration, should regard
continued growth of profits as more likely than not over the long
term, then why bother with CAPE at all? Why not rely on
forwardlooking estimates and dispense with the charade?
CAPE is Useless
I worry that I have failed to adequately demonstrate these
issues, but this is probably the best I can do for now. And, it
would be prudent for me to stop here, since the data, to my mind,
is fairly conclusive:
CAPE has only managed to predict returns when earnings
growth is constant, and if future earnings growth is constant, you
don't really need CAPE.
In conclusion, my analysis in previous articles suggested that
this market is in a period of secular P/E expansion ([[SPY]],
[[DIA]], [[QQQ]]) and weakness in commodities (
GSC
) and emerging markets ([[BIK]], [[FRN]]). The worrisome thing
about American stocks is not the otherworldly performance of the
last two years but rather the otherworldly performance of stocks
over the last sixty to eighty years. If we cannot come up with a
convincing account for this sea change in the markets and why it
may or may not continue in the future, we are forced to devise more
creative ways of looking at markets.
(click to enlarge)
Disclosure:
I 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. I have no business relationship with
any company whose stock is mentioned in this article.
See also
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on seekingalpha.com