Pros & Cons of Shiller’s CAPE

Your Weekend Reading on the CAPE
A model used to value stocks developed by Yale economist Robert Shiller has some distinct pluses and minuses. Bloomberg, August 22, 2014

 

 

 

In our discussion of Mr. Market, we made passing reference yesterday to CAPE, Yale professor Robert Shiller’s 10-year cyclically adjusted price-earnings measure. This led to quite a conversation via a series of e-mails and Twitter posts from an assortment of analysts and asset managers. I received research from or by Cliff AsnessMichael KitcesMebane FaberJeremy SiegelSalil MehtaStephen E. WilcoxDoug ShortWade SlomeErik Kobayashi-SolomonBen Carlson and Jesse Livermore. If you want a crash course in CAPE, spend the weekend digesting what they have to say.

Today, I want to focus on the pros and cons of CAPE, giving airtime to all sides of the argument. My main interest in CAPE has more to do with behavioral issues such as confirmation bias by those who cherry pick CAPE as their preferred valuation metric when it suits their market position.

Let’s start with a few words about valuation and timingCyclically adjusted price to earnings uses the prior 10 years of trailing per-share earnings rather than just the previous four quarters. This reduces the short-term volatility. In theory, it should include at least one full business cycle, and possibly more. Shiller has said that he was trying to develop a valuation metric that would tell an investor whether equities were likely to outperform their median returns during the next decade.

Shiller’s CAPE does this well. As Faber of Cambria Investment Management observed, when CAPE measures are less than 10, future 10-year returns are outstanding. Over the long run, returns fall the higher CAPE rises. However, in the short run, it is anyone’s guess. As Kitces has noted, CAPE is terrible as a market-timing tool, but it does add value for long-term retirement planning.

Why then all the carping over CAPE? Let’s take a quick survey of what CAPE does well, it’s weaknesses and how it should be used.

Consider what CAPE does well:

1) Expected Returns: CAPE is good at providing expected 10-year equity returns. Stated simply, when CAPE is elevated, expected returns tend to fall; when it is depressed, expected returns rise. Not many other indicators can make this claim.

2) Market Peaks: When readings of CAPE are at very high (typically top quintile) it can signal a market top. In 1929 and 2000 CAPE levels were higher than 30.

3) Market Bottoms: When CAPE measures are at extreme lows, it generates an excellent long-term entry point into equities. Investors should consider CAPE readings in the lowest quintile as very inexpensive markets.

The measure of CAPE is simple, clean, easy to understand, and has a century-long track record. Thanks to Shiller, it was well-conceived and objective. These qualities suggest a usefulness and legitimacy that not many other metrics can claim to match.

 

 

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