One of my favorite investment writers, and now also podcaster, is Meb Faber. He always has great insights backed up by lots of data. However, one of the things that I disagree with him on is the usefulness of CAPE (Cyclically Adjusted Price Earnings) as a valuation metric. His latest post on the subject (link here) does a great job of framing the CAPE argument not as an either or, but as an option among many investment alternatives, which is certainly the correct perspective. While the post was thought provoking, and presented a lot of back data to support the metric as an investment decision tool, it did not address my main concerns with using CAPE as an asset valuation tool. For the uninitiated readers, I’ll get you caught up, and then go into why I don’t think serious investors should rely on CAPE to assess value.
What is CAPE?
The CAPE ratio is “cyclically adjusted” which just means that instead of looking at the last twelve months of earnings like a “current PE” ratio would, it takes the average of the last ten years of earnings. It is also known as the Shiller PE, from Robert Shiller, who popularized the term in his book Irrational Exuberance. The rationale behind the averaging of earnings (or smoothing) is to adjust for the outliers in earnings that might give false readings for a company’s current price-to-earnings PE ratio.
For instance, if a company has a windfall earnings season in one year (due to recognizing gains from the sale of assets as an example), the E of earnings will grow, and therefore for the stock will look cheaper from a PE perspective. If analysts buy based on a perceived discount in value, that will take the P up to close the value gap. However, the next year, when the windfall is removed from earnings, but the Price is still elevated, now the stock will appear to be expensive from a valuation perspective. See the info-graphic below.
In order to adjust for these windfalls and to account for earnings over an entire business cycle, an analyst will look at the last ten years of earnings and give an inflation-adjusted average number. This means that an analyst is looking for the price of stock based on its average earnings over a business cycle.
Intuitively, this makes sense – let’s see what a company makes over a business cycle and compare that to the price we pay. What’s not to like?
But before I get to that, Meb Faber has not only invoked the godfathers of value investing (Graham and Dodd) in citing the logic of smoothing out earnings over the course of a business cycle, but he also explained the historical benefit of buying “cheap” and selling “expensive” markets based on the CAPE metric using actual past returns.
The title of his post, You Would Have Missed 780% In Gains Using The CAPE Ratio, And That’s A Good Thing, takes a popular criticism head on. The argument essentially says that stocks appeared expensive on a CAPE basis back in 1993 so if you would have sold out you would have missed on the entire run of the 1990’s and over the course of the following 20 years would have missed out on 780% of gains. Faber argues, correctly, that investors have more choices than just being in or out of stocks, and that if they would have purchased either bonds, or looked for a cheap international market to invest in instead, they could have actually done quite well.
It is certainly an interesting study, but suggesting that it can be used as a buy/sell indicator on securities or markets suffers from a few fatal flaws.
First Flaw: CAPE penalizes growth
Imagine you are considering investing in Company A which is growing at 15% per year. Let’s say the current PE is 25 on $5 of Earnings per share. If you tried to look back at the last ten years of earnings you would see that if you inflation adjusted at 3%, the average earnings would be 3.16 and CAPE would shoot to almost 40! This company looked a little pricey with a current PE of 25, and now looks hugely expensive using CAPE.
Now let’s look at a Company B which also has a current PE of 25 on $5 of earnings per share but it only grows 5% per year. This company would have an average EPS over the 10 years of $4.58 and therefore would have a CAPE of only 27.29. Even though Company B looks cheaper on a CAPE valuation, which would you rather own? The high growth company at a CAPE of 40? or the low growth company with a CAPE of 27?
Ten years is a lifetime these days, and taking the average of the last ten years of earnings values some companies based on their infancy, which no one could recommend. Therefore, applied broadly, it does not adjust for cycles as the name implies, but rather assigns value based on past secular stages which is detrimental to high growth companies.
Second Flaw: CAPE will change as earnings fall off the back-end.
I ran a projection to see what would happen to CAPE if the earnings on the S&P 500 increased from 12/31/15 of $88.43 by 5% for the next 5 years, and the price of the S&P 500 went up from its current level of approximately $2,250 at the same 5%. So, if everything moved up in lock step, how would CAPE value the market?
Well it turns out that even if price and earnings grow at the same levels, the market will get cheaper as the years of the great recession fall off the back end. Specifically, the years 2018 and 2019 will no longer have the great recession to drag down the average earnings and so the markets will end up get cheaper on a CAPE basis with nothing else happening. If the price and the earnings grow at the same amount, the current PE remains the same, however, CAPE falls. Just because the great recession earnings are no longer added in, why should you believe that the market is more valuable or cheaper? Nothing has happened in this illustration which should changes anyone’s view of market value.
Third Flaw: The evidence that CAPE “works” is really just a study in price mean reversion and ignores the operating environment of the market.
In his article, Faber posted the following great chart which showed a distribution of 10 year returns, color coded by their starting CAPE values. This shows that expensive CAPE years (in red) tend to cluster towards the left end of low returns, while the cheaper CAPE markets (in dark green) tend to have more impressive 10 year returns.
He comments on this chart with the following insight:
“Any investor who has been in the markets for long enough won’t be surprised by this. Markets don’t always behave as we expect, or want. But as the chart above illustrates, while you can’t be certain of an outcome, you absolutely put the odds in your favor by investing in cheaper CAPE markets, while avoiding expensive CAPE markets.”
This is not an incorrect statement; however, I do not believe these CAPE values are capturing value as much as they are just capturing the previous ten years of price returns. It is also correct to say that if a market suffers ten years of anemic results, then it has a higher likelihood of seeing better results in the next ten years. This is very simple reversion to the mean.
To illustrate my point, I ran a regression on the change in monthly price compared to the monthly change in current PE, CAPE, and the 10-year rate. Over the last 20 years the change in CAPE was over 99% correlated to the change in price. This is intuitive simply because by averaging out the last ten years of earnings, you are washing that out as a metric. By point of comparison, the change in current PE is only 17% correlated to change in price, showing that changes in earnings carries more weight on the valuation.
What the CAPE price chart above really says, is just that if you have a market which averages 9% per year, then after a decade of 10% + returns, you are likely to see a decade of slightly lower returns. This is not incorrect, but again not a good capture of current value.
It also does not take into account the operating environment in which those returns were achieved. To fully assess value, one needs to know more than just the price of an asset and its past earnings stream. If you look back at your Finance 101 text books it will tell you that the value of any asset is the present value of all expected future cash flows. CAPE does not give us any of that information. Does anyone remember the Dividend Discount Model?
What is essential in this equation is the discount rate. Just because CAPE today is high, is this market expensive? Compared to what? If you look at the earnings yield on stocks (3.94%) compared to the ten year bond (2.4%), stocks are the cheaper option. Even the earnings yield on a CAPE basis is 3.67%. If you discount expected future growth by our current market interest rates, you will get a much higher value than if you did the same with the rates from 2005 and 2006. In other words, lower interest rates make financial assets more valuable.
Even looking at global markets as Faber suggests, does the CAPE ratio indicate the rate at which earnings should be discounted or their expected future growth? What it does is show you low CAPE countries (markets have been crushed) and high CAPE countries (markets have soared), and says that you have a high probability of those two markets mean reverting.
To be fair, Faber has never said that CAPE should be used in solidarity and has presented his research on using a CAPE strategy from the quant perspective. I don’t disagree with any of the data or results that he has presented, I just disagree with the conclusions that can be made from those results.
The fact is that CAPE just simply does not capture value correctly on a lot of companies and therefore, is flawed to use on a market as a whole. Again, I go back to looking at the value of an asset being the present value of all expected future cash flows. Current PE has the same flaws, but the weakness of being backward looking is exacerbated by averaging the last ten years of data. I would also argue that in this low rate environment, the traditional measures of cheap and expensive need to be carefully evaluated. If you are not putting interest rates, expected inflation, and growth into your calculations, then any determination of value will be flawed.
So, if you are looking for a simple rule based computer program to run your money for 30 years, you could do worse than a CAPE switching strategy. However, if you want to be a really incredible investor, listen to Edna when she says “NO CAPE”!
Until next time…
“Price is what you pay. Value is what you get.” – Warren Buffett
*data comes from multpl.com. Data available upon request