More Issues With the CAPE

In yesterday’s New York Times, David Leonhardt wrote that stocks are still too expensive. He based this on the cyclically-adjusted P/E Ratio (CAPE) which is similar to the normal P/E Ratio except that it uses the average earnings for the past ten years.

I’m not a big fan of this metric for a few reasons. For one, it has a poor track record. The biggest reason is that earnings are cyclical and therefore, so is the market. As a result, I don’t see why the cycle needs to be adjusted. Not only that, the cycle is the most important part.

Also, Robert Shiller (the major proponent of CAPE) uses reported earnings which I don’t think is the best measure. In my opinion, operating earnings give you a better picture of what’s really happening. There were barely any reported earnings in 2009 which artificially inflated P/E Ratios. That glitch will be embedded in the CAPE for several more years.

Leonhardt notes that the CAPE is currently at 20.7 which is 6% above its 50-year average of 19.5. First, 6% above average is hardly “expensive.” Second, if you followed that metric, you would have been out of stocks for almost the entire past 20 years.

Leonhardt wrote:

But the 10-year ratio does have a pretty good track record. In 2007, when many Wall Street traders and economists were claiming that stocks were still a great buy, the 10-year ratio knew better. Likewise, it helped predict the market’s rebound in early 2009, when optimists were not easy to find.

That’s not correct. By following the 19.5 CAPE rule, you would have missed almost the entire 1990s bull market and would have gotten into stocks only between October 2008 and November 2009. Shiller himself said that the market was fairly valued in July 2009 when the S&P 500 was at 900.

Posted by on August 5th, 2011 at 3:24 pm


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