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Posts Tagged ‘Shiller PE10’

There are two great new papers on the global “predictiveness” of the Graham / Shiller Cyclically Adjusted Price Earnings (CAPE) ratio. The first, Value Matters: Predictability of Stock Index Returns, by Natascia Angelini, Giacomo Bormetti, Stefano Marmi, and Franco Nardini examines the ability of the CAPE to predict long-run stock market performance over several different periods in developed markets like the U.S., Belgium, France, Germany, Japan, the Netherlands, Norway, Sweden and Switzerland. From the abstract:

The aim of this paper is twofold: to provide a theoretical framework and to give further empirical support to Shiller’s test of the appropriateness of prices in the stock market based on the Cyclically Adjusted Price Earnings (CAPE) ratio. We devote the first part of the paper to the empirical analysis and we show that the CAPE is a powerful predictor of future long run performances of the market not only for the U.S. but also for countries such us Belgium, France, Germany, Japan, the Netherlands, Norway, Sweden and Switzerland. We show four relevant empirical facts: i) the striking ability of the logarithmic averaged earning over price ratio to predict returns of the index, with an R squared which increases with the time horizon, ii) how this evidence increases switching from returns to gross returns, iii) moving over different time horizons, the regression coefficients are constant in a statistically robust way, and iv) the poorness of the prediction when the precursor is adjusted with long term interest rate. In the second part we provide a theoretical justification of the empirical observations. Indeed we propose a simple model of the price dynamics in which the return growth depends on three components: a) a momentum component, naturally justified in terms of agents’ belief that expected returns are higher in bullish markets than in bearish ones; b) a fundamental component proportional to the log earnings over price ratio at time zero. The initial value of the ratio determines the reference growth level, from which the actual stock price may deviate as an effect of random external disturbances, and c) a driving component ensuring the diffusive behaviour of stock prices. Under these assumptions, we are able to prove that, if we consider a sufficiently large number of periods, the expected rate of return and the expected gross return are linear in the initial time value of the log earnings over price ratio, and their variance goes to zero with rate of convergence equal to minus one. Ultimately this means that, in our model, the stock prices dynamics may generate bubbles and crashes in the short and medium run, whereas for future long-term returns the valuation ratio remains a good predictor.

Figure 1 from the paper (extracted below) shows 2 year to 16 year regressions for the period 1871-2010 (Points are organized in chronological order according to the color scale ranging from dark blue to red passing through light blue, green, yellow, and orange; labels in the top left panel refer to points corresponding to the first month of the specified year.):

The second paper, Does the Shiller-PE Work in Emerging Markets? by Joachim Klement examines the reliability of CAPE as a forecasting and valuation tool for 35 countries including emerging markets. Klement finds that CAPE is a reliable long-term valuation indicator for developed and emerging markets. Klement uses the indicator to predict real returns on local equity markets over the next five to ten years (shown in Exhibits 11 and 12 extracted below):

Developed Markets

Emerging Markets

Klement makes some interesting observations about developed markets:

Looking at the forecasts for different markets the following observations stand out:

For all developed equity markets the expected real return in local currencies is positive and the probability of negative real returns after ten years is generally low.

The market with the lowest expected future return is the United States which together with Canada and Denmark promises real returns that are quite a bit lower than developed markets overall.

• Because of the low expected returns for US stock markets, an equal weighted portfolio of developed market equities is expected to perform significantly better than a typical value weighted portfolio. The current debate about optimal sector and country weights in a stock market index is still ongoing and there are many different rivaling approaches like equal weighting, fundamental weighting, GDP-weighting or equal risk contribution or minimum variance. The jury is still out which one of these approaches is the best for long-term investors, but our calculations indicate that an equal weighted portfolio should outperform a value weighted one.

• Looking at individual markets again, we see that the most attractive markets are generally the crisis-ridden European equity markets and in particular Greece which currently has such low valuations that real returns over the next five years could come close to 100%. But more stable markets like Finland, France or Germany also offer attractive long-term return possibilities.

And Klement on the emerging markets:

While the forecasts for emerging markets generally have a somewhat higher forecast error associated with them we can still observe some general trends:

Emerging market equities seem to be poised for significantly lower real returns than developed equities at the moment.

• Particularly smaller emerging countries like Peru, Colombia or Indonesia offer less attractive returns at the moment than more developed neighbors like Brazil or Thailand.

Some currently fashionable investment countries like China or India offer only average return prospects.

• From a regional perspective it seems that Eastern European countries together with Turkey and South Africa offer the highest future equity markets while Asia overall should be only average and in Latin America only Brazil seems a worthwhile investment at the moment.

H/T World Beta

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My post on the Shiller PE10 ratio calculated using Shadowstats’ alternate to the BLS CPI generated some great discussion about the various flaws in the market-level PE and PE10 – using BLS CPI or Shadowstats’ CPI – ratios. Brett Arends’s WSJ.com ROI blog has a timely post Why Stocks Still Aren’t Cheap examining other measures of stock market valuation. Says Arends:

There’s no one perfect guide to whether the market is cheap or not, but here are a few measures that may give you pause.

Take the so-called “Cyclically-Adjusted Price-to-Earnings” ratio, which compares share prices, not simply with one year’s profits, but with average earnings across an economic cycle of about 10 years. (This CAPE is often known as the “Shiller PE” after Yale economics professor Robert Shiller, one of its leading proponents.)

The CAPE has been a pretty good guide for investors over a very long period of time. It told you, correctly, to get out of stocks in the late 1920s, the mid-1960s, and the bubble a decade ago. It told you to buy aggressively after the second world war, and in the “death of equities” period of the 1970s and early eighties.

Over the past century or so, the stock market has, on average, been about 16 times cyclically-adjusted earnings. Today, it’s about 20 times. Make of it what you will. But it’s not cheap.

Or take the lesser-known “Tobin’s q.” A calculation, named for the late economist James Tobin, that compares stock prices with the replacement cost of company assets. It has a very similar track record to the Shiller PE.

The q on the market is about 1 today, says economic consultant Andrew Smithers. The historic average is just 0.64. By this measure, the market would have to fall a third just to reach its average. Again: This is cheap?

Or take another measure, “price to sales.” This compares stock prices to corporate revenues, rather than earnings. The rationale is that sales tend to be less volatile from year to year. This data, from FactSet, goes back to 1984. By this measure, shares certainly look a lot cheaper than they were in 2000 or 2007. But they are still much higher than they were before the bubble began in 1995. Ominously, they are higher today than they were just before the crash of 1987.

Still hungry for more? Consider another measure, “enterprise value to EBITDA.” This compares the value of all company stocks and debts with earnings before interest, taxes, depreciation and amortization–a key measure of operating cashflow. Many companies recently have been levering themselves up, borrowing more in the bond market. But all shares and bonds must, ultimately, be supported by cashflows. By this measure, share prices are still way above levels seen prior to the last 13 years.

Finally, you could try comparing the market value of equities with total U.S. gross domestic product. Once again, that’s been a reasonable guide to some of the great buying and selling opportunities of the past. Data from Ned Davis Research show that U.S. stocks are valued at about 85% of GDP today. The historic average, says Ned Davis Research, has been about 60%.

None of these measures is conclusive. None is perfect on its own. And, critically, none is any kind of guide to short-term movements. The market could jump 1,000 points next year just as easily as it could fall 1,000 points.

The four charts in the article are worth viewing.

Jeff Miller weighs in at A Dash of Insight with a critique of the Shiller PE10 as an alternative to forward earnings estimates:

There is a constant drumbeat of criticism about market valuation using forward earnings. The most common criticism, that estimates are too optimistic, is open to challenge. If the estimates are too high, why is the beat rate consistently in the 65% range?

The fans of the Shiller 10-year past earnings method take pride in having solid data. Then they make a wild guess about whether the trend will continue. Those praising this method point to a few notable successes, mostly times when P/E ratios were very low since interest rates were very high.

Those interested in forward earnings are taking the aggregate work of dozens of specialists. If you think they are a little high, you can feel free to add an error range. If you do so, you should look at past data — especially that of recent years.

These points are blindingly obvious, yet widely ignored.

Here is an offer for anyone who thinks that using ten years of past data is the best method: Send me an email and I’ll show you how to enter a nice football pool. The smart money will welcome you and Dr. Shiller.

I prefer Arends’s conclusion:

One should usually give stocks some benefit of the doubt. After all, over the long term they have produced better returns on average than other assets. From that it follows that they have generally been undervalued in the past.

So maybe today stocks are very expensive. Or maybe they’re just no great bargain. But it is almost impossible to argue that they are very cheap. If this were a great contrarian moment to buy stocks, they’d be very cheap.

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Saturna Capital has an interesting take on the calculation of the Graham / Shiller PE10, otherwise known as the Cyclically Adjusted Price Earnings ratio (CAPE). Saturna argues that The Market May Be Cheaper Than It Looks because the Consumer Price Index (CPI) provided by the Bureau of Labor Statistics (BLS) understates the true rate of inflation, a key input to the CAPE calculation:

Potentially Understated Inflation

Given that inflation estimates play an influential role in the calculation of the P/E10, it is important to investigate the assumptions behind the calculation of inflation. Traditionally, inflation is measured using the Consumer Price Index (CPI) provided by the Bureau of Labor Statistics (BLS). The CPI estimates inflation by measuring fluctuations in the average price of a basket of consumer goods and services that is deemed to be typical of the average urban consumer. However, due to a variety of reasons, largely political, the methodology used to calculate CPI has undergone many changes in the past 10 to 20 years. One of the most controversial changes was to alter the composition of the basket to reflect changes in consumer behavior over time.

In doing so, the BLS hoped to remove biases that cause the CPI to overstate the true inflation rate. Former chairman of the Federal Reserve Alan Greenspan advocated this alternative methodology, arguing that if the price of steak went up, consumers would choose to eat more hamburger meat instead.² He therefore concluded that unless hamburger meat replaced steak in the basket, inflation would be overstated because consumers were not actually spending more money. Skeptics view these changes as government manipulation, the purpose of which is to understate the true inflation rate, as well as the wage and other rate increases indexed to it (think Social Security).

Saturna uses an alternative measure of inflation: the Shadow Government Statistics’ (SGS) Alternate CPI:

Over time this recalibration of the CPI has produced lower inflation estimates than the “old school” method. In fact, the discrepancy has become rather large… Unlike Mr. Greenspan, however, we prefer steak to hamburger meat. Accordingly, we tend to believe the truth lies somewhere in between the BLS’s CPI and the Shadow Government Statistics’ (SGS) Alternate CPI.

The implications for CAPE using Shadow Government CPI are as follows:

The wide gap between the government-sanctioned CPI and the Shadow Government CPI presents a competing set of assumptions about how to measure the effect of rising prices on the average consumer and the market as a whole. The relevance to investment analysts is that higher inflation figures can have a dramatic impact on the current P/E10 ratio. For example, if inflation is assumed to be 5% annually, $1 in nominal earnings from 10 years ago would be worth approximately $1.63 in today’s dollars. At 10% annually, $1 in nominal earnings from 10 years ago would be worth about $2.59 today. Using a higher inflation estimate therefore increases average real earnings over the 10-year period, and thus lowers the P/E10 ratio. If we assume the SGS figures are correct, then the current P/E10 based on the average closing price during the month of June is about 14x (see chart below). This ratio is much lower than the current P/E10 of near 20x using traditional CPI figures.

Click to View

Read the article.

Hat tip Ben Bortner.

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