Wednesday, September 20, 2017

Valuation Debate: Shiller vs. Goldilocks

The valuation question has been hanging over the current bull market. Valuation ratios such as price/earnings, price/sales, and market capitalization/revenues are uniformly bearish, showing that stocks are as overvalued as they were just before the tech bubble burst in 2000. On the other hand, valuation measures that adjust for inflation and interest rates, both of which are near record lows, suggest that the market is fairly valued. They are mostly in the Goldilocks range: Not too cold, and not too hot. I have been siding with Goldilocks.

Not surprisingly, Yale Professor Robert Shiller strongly disagrees with Goldilocks. He is issuing dire warnings that stocks are as grossly overvalued as they were in 2000. The man won the Nobel Prize in economics, so he must know something. He won primarily for his work on speculative bubbles, including his book Irrational Exuberance (2000). (Goldilocks dropped out of high school, and is now doing jail time for petty larceny.) The professor’s latest alarming views were reviewed last Friday in an article posted on titled “A Nobel Prize Winner's Dire Market Warning — And What To Do About It...” Here are some of the key points on the valuation question:

(1) Trailing P/E. The article observes: ”The price-to-earnings (P/E) ratio of the S&P 500 … is about 24.5. This is about 67% above its long-term average of 14.7.” My data, using four-quarter trailing earnings for S&P 500 operating earnings, show the P/E at 20.7 at the end of June, 37% above its long-term average of 15.1 since 1935. It is still well below its record high of 28.4 during Q2-1999.

(2) Forward P/E. The article focuses on backward-looking P/E measures, including Shiller’s CAPE, which is a cyclically adjusted measure based on earnings over the past 10 years. The four-quarter trailing P/E, using operating earnings, has exceeded the forward earnings P/E since 1989, which is when the operating data series starts. The latter was 17.7 in August. That’s high, but still well below the record high of 24.5 during July 1999.

(3) CAPE. The article notes: “Nobel Prize-winning economist Robert Shiller's cyclically adjusted P/E ratio is also warning the market is overvalued. At 30.2, this ratio is more than 85% above its long-term average of 16.1.” Jeremy Siegel, the professor who wrote Stocks for the Long Run (1994), has yet to win a Nobel Prize despite his great long-term call. In a 2016 FAJ article, he sides with Goldilocks and counters Shiller’s pessimism as follows:

Robert Shiller’s cyclically adjusted price–earnings ratio, or CAPE ratio, has served as one of the best forecasting models for long-term future stock returns. But recent forecasts of future equity returns using the CAPE ratio may be overpessimistic because of changes in the computation of GAAP earnings (e.g., “mark-to-market” accounting) that are used in the Shiller CAPE model. When consistent earnings data, such as NIPA (national income and product account) after-tax corporate profits, are substituted for GAAP earnings, the forecasting ability of the CAPE model improves and forecasts of US equity returns increase significantly.
(4) Rule of 20. The Rule of 20 compares the S&P 500 P/E, on either a trailing or forward basis, to 20 minus the CPI inflation rate on a year-over-year basis. In August, the CPI inflation rate was 1.9% y/y. According to the Rule of 20, that meant that the P/E should be around 18.1. The average of this measure is 16.6 since 1935. That’s historically high, though obviously because inflation is historically low. Again, as noted above, the four-quarter trailing P/E was 20.7 during Q2, while the forward P/E was 17.7 in August. By the way, the Rule of 20 was devised by Jim Moltz, my friend and previous colleague at CJ Lawrence.

(5) Misery-Adjusted P/E. Another valuation metric that I devised is simply the sum of the S&P 500 forward P/E and the Misery Index, which is the sum of the unemployment rate and the CPI inflation rate. I’ve observed an inverse relationship between the forward P/E and the Misery Index. That makes sense: When consumers are less miserable because unemployment and inflation are low, investors are happier too and willing to pay a higher multiple for earnings.

Adding the actual forward P/E and the Misery Index together produces the Misery-Adjusted P/E. It has averaged 23.9 since the start of the series in 1979. It was 24.0 during August, suggesting that stocks were fairly valued. This metric can be thought of as the Rule of 24: The fair-value forward P/E was 17.7 during August based on 24 minus the Misery Index, which was 6.3 last month.

(6) Real earnings yield. There’s an alternative valuation measure that is adjusted for inflation in a more rigorous fashion than is reflected in the two rules of thumb above. Let’s flip the P/E over and focus on the S&P 500 earnings yield (i.e., E/P). It can be calculated on a quarterly basis back to 1935 using S&P 500 reported earnings data. The real earnings yield is the nominal yield less the CPI inflation rate.

The average of the real earnings yield is 3.7% since 1935. When the yield is above (below) this average, stocks are undervalued (overvalued). The actual reading was 2.6% during Q2, suggesting that stocks were somewhat overvalued, but not excessively so. Excessive overvaluation would be reflected in a real earnings yield close to or below zero.

No comments: