Only fools and bourses – The ‘CAPE’ ratio can be useful but do not take it at face value

In November 2012, I entered the debate (The Shiller P/E: Alas, A Useless Friend) on the usefulness of the CAPE or Shiller P/E as an adequate valuation tool for the U.S. equity market with the following reasons:

• “Operating” earnings are a better gauge of index profits;
• Assessing current indices against the last 10-year earnings is flawed;
• Looking at past evidence, the Shiller P/E is simply useless as a market valuation tool;
• There is at least one alternative.

One of the main problems with the Shiller P/E approach has not been discussed by any other pundit until today. In 2012, I explained why the CAPE was not a fair valuation tool since 2008 given that

many of the companies that recorded huge losses in 2008-09 either went bankrupt or were substantially restructured or acquired. A conceptually valid valuation method like the Shiller PE, measuring 10-year average earnings against a current index, is thus including in its denominator, during 10 years, the huge losses recorded by companies that are no longer included in its numerator, these companies having in fact been replaced by other, profitable, companies.

Humongous or very large losses were recorded in 2008 by companies such as AIG, GM, Merrill Lynch, Marshall & Ilsley, MBIA, Wachovia, all companies then part of the S&P 500 Index but no longer. As to the dot.com bubble, everybody remembers the infamous Enron and Worldcom, just to name a couple. Their losses still impact the 10 year average earnings even though they have no contribution to the actual index value.

The losers are long gone but their losses remain!

This is like assessing a baseball team’s current batting line-up using 10-year data that includes the dismal stats of now deceased players. How useful is that?

Finally, somebody has awaken to this reality. Kevin Murphy, fund manager at Schroders, last week published the headlined article in which he used other examples to illustrate why CAPE is distorting valuations:

The British girl group Sugababes may not seem an obvious starting point for any discussion on the merits of value investing but please do bear with us. Sugababes started life in 1998 with a founding line-up of Keisha Buchanan, Mutya Buena and Siobhán Donaghy but one by one, over the course of the next 11 years, all three left the group – each time to be replaced by a new singer. 

Go to a Sugababes concert now and you would hear the group’s repertoire being performed by Amelle Berrabah, Jade Ewen and Heidi Range while, curiously enough, the original three members have reconvened under the eponymous banner of Mutya Keisha Siobhan, which Wikipedia helpfully informs us “is often shortened to MKS”. So – which would you consider to be the real ‘Sugababes experience’? 

Keen students of popular culture may recognise a similar philosophical conundrum cropping up in an episode of ‘Only Fools and Horses’ where the road-sweeper Trigger wins an award from the council for having owned the same broom for 20 years. He goes on to reveal it has had 17 new heads and 14 new handles, but insists it is still the same broom. Does Trigger have a point? 

Genius that he was, Plutarch foreshadowed both these vexing questions with his ‘Ship of Theseus’ paradox. Can a ship that is restored by replacing every single one of its wooden parts, the First Century historian and philosopher asked, remain the same ship? At the same time, we sense you asking, what has any of this to do with value investing? 

Well, here on The Value Perspective, we often refer to a metric known as the cyclically adjusted price/earnings ratio – ‘CAPE’ for short – which encapsulates the average earnings generated by a business, sector or market over the preceding 10 years, adjusted for inflation. And of course, over time, the constituents of sectors and markets can and do change. 

The peripheral eurozone is a topical enough example, with many companies that would have featured in the benchmark indices of Greece, Ireland, Italy, Portugal and Spain before the 2008 financial crisis now no longer with us due to insolvency. As it happens, at the start of 2015, all five markets featured among the cheapest in the world on a CAPE basis in a chart we ran in Cape of good hope.

Focusing in on Greece then, a comparison of the constituents of the Athens Composite index in 2006 and 2015 reveals just three of the 10 largest companies from nine years ago can still make that claim today. At a sectoral level, meanwhile, financial companies make up just a third of the Athens Composite at present, compared with half the index back in 2006. 

However, even though they may no longer exist, the constituents of the Athens Composite in 2006 are frozen in time as the profits or earnings power of Greece. Of course, given some of those stocks are no longer in the index, it would be foolish to work on the basis that that level of profits or earnings power is likely to come back any time in the near future. 

What this means for us as investors is that, when we are valuing stockmarkets, we need to recognise there are reasons those markets may not necessarily end up performing as strongly as the superficial headline ratio would suggest. Indeed, when we dig deeper, it can quickly become apparent there are nowhere near the number of opportunities within ‘cheap’ markets as the headline ratios might suggest. (…)

The point of our Ship of Theseus analogy (and the two shamelessly more populist variations on the theme) is that markets and sectors change and evolve. As a result, investors need to be careful about taking headline ratios at face value and so being fooled into buying an index that may not necessarily provide the returns that history would suggest. (…)

Back to U.S. equities, the main reason why the Shiller P/E has remained elevated throughout the last five years’ bull market is that its numerator has changed significantly while its denominator continued to include the huge losses incurred in 2000-2001 and in 2008-2009 by companies no longer in the Index. Losses incurred by the Enron’s of the internet bubble years are now out of the Shiller denominator but those of the financial crisis will keep knocking the denominator for another 3-4 years.

We are not talking about trivial numbers. In 2008, some eighty S&P 500 companies recorded $240 billion in losses, subtracting over $27 per share from the index earnings even though they accounted for only 6.4% of the index weight. Incidentally, the S&P Financial sub-index recorded “operating” losses in each and every quarter of 2008 for a yearly total of $21.24 (-$37.96 “as reported”). Many of the big losers are no longer, but CAPE still carries their losses.

CAPE 10-year earnings are currently $77 (rounded), some $36 (31%) lower than the current S&P 500 trailing operating earnings. It is not a mere coincidence that the difference between S&P’s normalized operating earnings and Shiller’s earnings peaked at $38 in March 2009. This gap will continue to artificially and deceivably inflate the Shiller P/E until December 2019.

Meanwhile, the Rule of 20 P/E, almost totally unknown or neglected by most pundits, continues to provide investors with dependable assessments of the risk/reward ratio for U.S. equities. This orphan valuation tool has not been endorsed by a Nobel laureate and is likely too simple to be used by economists and strategists in need of justifying their forecasts with circumvoluted formulas and thesis. Nonetheless, there is no better and dependable friend around.