The CAPE Crusader

Note: This market review was published on July 18th, 2014 and may not be reflective of current market or investing issues.

“The purpose of investing is not to simply optimize returns and make you rich.  The purpose is not to die poor.”

                                                                                    William Bernstein

“Holy Cow Batman!”  Wait a minute, you have the wrong crusader.  In the world of investing, it’s not Bruce Wayne of Gotham, but Robert Shiller of Yale.  And it’s not Caped, but CAPE (Cyclically Adjusted Price Earnings).  Shiller is a recently named Nobel Laureate, professor of economics, the developer of the Case-Shiller Real Estate index, the author of the well-timed book Irrational Exuberance, and oh yes, the originator of CAPE.

The CAPE valuation method uses per-share earnings normalized over a past 10-year period, which tends to smooth earnings (and then also the price / earnings ratio) over a typical business cycle.  The current valuation is 26 times earnings.  Leuthold/Weeden, a prominent financial research firm, uses a slightly different method calculated over a five-year period, and their ratio is currently valued at 21 times earnings.  Both of these P/E valuations are above their respective average value, in both cases above the 80th percentile, at least when the exercise is applied to domestic stocks.

The concern from Shiller, James Montier of GMO and other market pundits is not that the domestic market is just expensive.  It is really that based on past history when the market was this expensive on a CAPE basis, five-year future market returns have been flat to negative.  Shiller’s graph, included below, shows that his index has only been more expensive than now in three years, 1929, 2000 and 2007.  Uh oh! Obviously, price / earnings ratios are not the only (or even the best) market valuation tool.  The trailing twelve-month P/E ratio is only 18.8, and the forward-looking ratio (as if we can predict the future) is even lower.  U.S. corporate earnings have remained persistently strong over the last five years and with a near zero interest rate, some premium in the ratio may be justified.  Our markets have done very well since 2009 compared to other markets around the world, and domestic stocks are now more richly valued.  It does make sense to slowly move away from our high valued stocks into less expensive areas of the world, especially Europe and emerging markets, if one has the stomach for uncertainty.  It may also be prudent to begin to accumulate a little more cash, as we see some of our fund partners doing.  Bottom line:  U.S. stocks have done very well, but are no longer inexpensive compared to most of the world.  Time to be careful out there!

My many thanks to Robert Shiller, James Montier and William Bernstein for their continued research, and frequent articles and books.  I have used and abused their thinking many times over the years.  If you want more, Shiller’s website is www.econ.yale/edu-shiller/data.

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