The cyclically adjusted P/E ratio is a better indicator of a cheap investment.
The conventional P/E ratio has two advantages; its ease of calculation (the current price of an asset, or market, divided by its historic earnings), and its ubiquitous use.
Although frequently quoted as an indicator of market valuation, and potential future returns, it has an irritating flaw; in boom times when earnings are high the P/E can appear reasonable and in times of bust the P/E can appear expensive.
Since profits revert to a mean over an economic cycle, it would appear more rational to smooth the P/E ratio to take account of this cycle and give a fairer picture of value. This is the objective of the cyclically adjusted P/E ratio (CAPE), and it has proved to be a reasonable indicator of future returns.
A long and profitable history
Warren Buffett attributes much of his success to learning investment from Benjamin Graham, the 'dean of Wall Street' and CAPE is first mentioned in his seminal work, "Security Analysis", published in 1934. In the book Graham, and co-author Dodd, recommended a CAPE using a moving average of earnings over not less than five, and preferably seven or ten years.
Try as I might, I can't find much evidence to suggest that Graham and Dodd provided extensive research into just how much better CAPE was to its alternative. In any case ,it appears to have been neglected for much of the 20th century until Yale professor Robert J. Shiller.
Shiller developed the concept for his analysis of markets from the early 1990s, which culminated in his ground breaking book "Irrational Exuberance". Published with impeccable timing in 2000, it predicted a decade of low returns based on CAPE. Coincidentally, he also published a book on US housing in 2005 which forecast -- you guessed it -- substantial falls in that market. Shiller is worth listening to!
The validity of using CAPE as an indicator of long-term returns was demonstrated by Shiller in a 1996 paper, "P/E ratios as Forecasters of Returns". Further evidence of the power of CAPE, this time applied to individual shares, was provided in a book by analyst James Montier, "Behavioural Investing".
Montier and a colleague applied CAPE to buying (and short selling) low and high P/E shares from 1980 to 2005 using the MSCI World Index. The ten-year CAPE was significantly better at selecting under priced, and over priced, shares then the conventional P/E ratio. In fact, CAPE outperformed the market by 13% a year, compared to 5.5% outperformance using a one year trailing P/E.
In 2007, when the conventional P/E ratio was signalling the UK market to be fair value, renowned analyst Andrew Smithers, who uses the ten-year CAPE, argued that the UK market was 68% overvalued. Now that the market has retreated from those heights, it may well be appropriate to look at what the current CAPE is and what, if anything, it is signalling.
Is the UK market good value?
The current CAPE is near its long-term average and is signalling the market is fair value, but there may be better buying opportunities.
First of all a caveat. CAPE averages are only applicable to the US market and the S&P 500 in particular, where they can be calculated back to 1881. Because of changes in taxation, reliable earnings per share (EPS) over the long term, equivalent figures are unavailable for the UK market. However, since the UK has a high correlation with the US market, CAPE-based indicators should remain valid for the UK investor.
The long-term average of CAPE is about 16. In March, at the recent market low, CAPE reached 11.4 about 14% below the median low level of the last 26 recessions.
At the time of writing, CAPE stands at 15.3. Indeed for the last seven or eight months it has been below the average level. For the first time in 17 years. Yes, that's right. 17 years! This is certainly no hair-triggered daily, momentum type indicator we are talking about here.
So is the market a screaming buy? No. The consensus among CAPE followers seems to be that the market is about fair value. Business Insider's Henry Blodget reckons "over the next couple of decades, the S&P 500 will deliver an average long term return (6%-7% real)".
Meanwhile, the man himself, Robert J Shiller, reckons that CAPE may well overshoot on the downside. He'd start filling his boots when the CAPE hits 10 or less.
How do I see it? Well, the peak of CAPE in 2000 was 45, in 2007 it was 28. Now it's about 15. I'm inclined to invest now. As The Economist pointed out on 12 May, "anyone who bought shares in 1931, well before the market bottom the next year, still earned 6.9% over the next ten years. Almost bang on average." I love average.
All of Shiller's extensive data is available free on his website in excel format. You can also play around with a useful little calculator which reveals historic future returns on the S&P 500 at various ten-year CAPE levels.
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