Context Is Key: Don’t Look At CAPE In A Vacuum

By Mani
Updated on

Cyclically Adjusted Price Earnings (CAPE) multiple should be looked at more deeply by considering the context around it, points out Citi in its recent report.

Tobias M Levkovich and the team at Citi Research note operating versus reporting earnings can generate very different CAPE outcomes.

CAPE to be worn appropriately

Citi analysts point out that in the face of high after-tax corporate margins aided by Fed-induced low financing rates, valuation has become the focus of discussion among investors. The analysts note that while various measures could argue for higher valuations including improvements in equity risk premiums or P/Es relative to inflation rates (as highlighted in the graph below), the locus of the argument has become the CAPE ratio.


Shiller Vs IBES

Citi analysts point out in the CAPE ratio, one looks at rolling 10-year averages on earnings to normalize the EPS trend, though there are several problems with the way it is debated.

For instance, the Citi analysts point out Professor Shiller of Yale University uses Standard & Poor’s estimate of earnings, which is not consistent with the Street’s usage of widely accepted Institutional Brokers’ Estimate System (IBES) estimates. IBES estimates is the number crunched by the consensus of analysts’ determination of operating earnings for the 10-year figures.

According to Tobias M Levkovich and the team at Citi Research, Shiller’s conclusion using the S&P estimates is that the CAPE valuation is excessive. However, as can be evidenced from the following graph that considers reported earnings, the valuations don’t look that extreme:

SP500 10year rolling

As in all things, context is key

Citi analysts point out the above concepts can’t be looked on in a vacuum. For instance, the analysts point out that if one wants to normalize one side (viz.: equities) of the Fed Model type structure by using rolling 10-year average earnings, then one should also has to normalize the bond yield for cyclical factors as well.

Hence, Citi analysts use the five-year forward contract for expectations of the 10-year Treasury yield, which was surprisingly never mentioned by the proponents of donning CAPEs for stock market valuation.

The following graph highlights the relationship between both the current 10-year bond yield and the 5-year forward expected 10-year yield at every point in time looking back over 40 years. It is evident investors do have long-term looks of more normalized government debt conditions.

Normalized earnings yield gap


Citi analysts perceive it as necessary to think a bit more deeply than just trying to simplify a measure such as CAPE without any context around it. The analysts point out their P/E Bulls-Eye approach also uses such simplified methodology using trailing 12-month EPS for the P/E calculation. Interestingly, even current levels argue for as much as mid to high single-digit gains in the next year. The following graph illustrates the valuation Bulls-eye:

Bulls eye

Based on a review of 3Q13 results, Citi analysts have revised 2013 EPS estimates at $110.10 while for 2014, it is revised upwards to $117.50, as against the earlier estimates of $109.50 and $116.25 respectively. The analysts have also projected preliminary 2015 S&P 500 estimates at $126.00.

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