Beware Of The Misinterpretations Of The CAPE Ratio

Beware Of The Misinterpretations Of The CAPE Ratio

Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives. This article originally appeared on ETF.COM here.

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With the Shiller CAPE 10 ratio having risen above 31, more and more investors are becoming worried about both the outlook for future equity returns and the possibility of mean reversion in valuations, which could lead to a bear market.

The concern about future returns is justified by the fact that, while the academic research shows valuations are an extremely poor forecaster of stock returns in the short term, they are the best predictor of long-term returns. A CAPE 10 of 31 translates into a real-return forecast for U.S. stocks of less than 3%. Add in 2 percentage points for expected inflation and you get a nominal return of about 5%, half the size of the historical return. Let’s look at some of the evidence.

In his November 2012 white paper, “An Old Friend: The Stock Market’s Shiller P/E,” Cliff Asness showed that 10-year forward average real returns fall nearly monotonically as starting Shiller CAPE 10 ratios increase.

In addition, as the starting CAPE 10 increases, worst cases get worse and best cases get weaker (the entire distribution of returns shifted to the left). However, there were still very wide dispersions of returns. For example, even when the CAPE 10 ratio was above 25, the best 10-year real return was 6.3%, less than 1 percentage point below the historical average. Such wide dispersions explain why the CAPE 10, while it provides information on future returns, should not be used as a tool to time the markets.

Javier Estrada came to the same conclusion in his study, “Multiples, Forecasting, and Asset Allocation,” which was published in the Summer 2015 issue of the Journal of Applied Corporate Finance. He examined the benefits of using valuations as a tactical asset allocation tool and found “the evidence does not support the superiority of valuation-based strategies; if anything, it points moderately in the opposite direction.”

While U.S. equity valuations clearly are at historically high levels, is the outlook as bleak as it seems? Perhaps not. Let’s see why that is the case.

Changing standards

To begin, in 2001, the Financial Accounting Standards Board changed its rules regarding how goodwill is written off.

As a post on the blog Philosophical Economics explained: “In the old days, GAAP required goodwill amounts to be amortized—deducted from earnings as an incremental non-cash expense—over a forty-year period. But in 2001, the standard changed. FAS 142 was introduced, which eliminated the amortization of goodwill entirely. Instead of amortizing the goodwill on their balance sheets over a multi-decade period, companies are now required to annually test it for impairment. In plain English, this means that they have to examine, on an annual basis, any corporate assets that they’ve acquired, and make sure that those assets are still reasonably worth the prices paid. If they conclude that the assets are not worth the prices paid, then they have to write down their goodwill. The requirement for annual impairment testing doesn’t just apply to goodwill, it applies to all intangible assets, and, per FAS 144 (issued a couple months later), all long-lived assets.”

While FAS 142 may have introduced a more accurate accounting method, it also created an inconsistency in earnings measurements. Present values end up looking much more expensive relative to past values than they actually are. And the difference is quite dramatic. Adjusting for the accounting change would put the CAPE 10 about 4 points lower.

Relying on the CAPE 10’s long-term historical mean as a yardstick for stock valuations is problematic for another reason: There has been a dramatic change in dividend policy, with fewer companies paying dividends now than in the past.

Read the full article here by Larry Swedroe, Advisor Perspectives

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