Research Articles

Prof. Schiller and CAPE, Maybe Correct Generally, But Specifically Wrong: The Market is Currently Cheap

Julie C - Wednesday, October 12, 2011

Introduction

Many well-known stock market pundits to include the likes of Henry Blodgett point to Professor Robert Shiller’s cyclically adjusted PE ratio or CAPE to make a case that the stock market (S&P 500) is overvalued.  According to Prof. Shiller, the long-term average PE ratio (CAPE adjusted) for the S&P 500 is approximately 16.  And today, according to CAPE (cyclically adjusted PE) the S&P 500 sits at a CAPE PE ratio of approximately 24 or so.  Therefore, according to the statistical analysis, the S&P 500 is 20% to 30% overvalued.

The thesis of this article is that although Prof. Shiller may eventually end up being correct, and we emphasize “may”, his hypothesis is vague and imprecise, and therefore, too general to be of value.  On the other hand, we emphatically hold that he is absolutely wrong regarding specific blue-chip US corporations.  Furthermore, we also contend that on an absolute basis (precise calculation of earnings) that the S&P 500 is undervalued based on historical norms.

Therefore, we are concerned that these statistically inferred measurements of so-called overvaluation could deter investors from investing in or owning our best companies at precisely the time when their valuations are low and the long-term rewards for investing in them are better than they have been in decades.  Furthermore, thanks to these low valuations the risk of owning blue-chip stocks is simultaneously also lower than it has been in a long time.

What CAPE Really Says

Prof. Shiller's cyclically adjusted PE ratio (CAPE) calculates an average of 10 years of S&P 500 earnings, which is used as the level of earnings with which to divide into the current price of the S&P 500 in order to determine the CAPE PE ratio.  This calculation, which theoretically takes into consideration the cyclicality of the S&P 500's earnings, is promoted as being superior to forecasting future earnings.  However, we will soon demonstrate that this is precisely what the CAPE measurement is doing; predicting or forecasting future earnings.

Furthermore, the only way that it can be of true value is if its implied forecast is correct in future time.  Of course, it should also be recognized that this is no different than any other forecast methodology.  The veracity of the assumptions underlying the hypothesis can only be proven if they produce an accurate future level of earnings, in this case for the S&P 500.  Also, to be of any real value to investors, CAPE needs to offer a precise point in time when earnings are allegedly going to fall.

Mathematically, the actual forecast behind CAPE in the vast majority of cases is forecasting a lower-level of future earnings on the S&P 500.  This is because the S&P 500 earnings are generally increasing and only interrupted by the occasional recession.  Therefore, CAPE is suggesting that the S&P 500 is overvalued based on a vague notion about future earnings, not current earnings.

Another claim that CAPE makes as being a superior methodology is that it uses as reported earnings in contrast to operating earnings like most other prognosticators use.  According to Standard & Poor's website, the following definitions to these earnings measurements are as follows:

"Operating earnings: income from product (goods and services), excludes corporate (M&A, financing, layoffs) and unusual items."

"As reported earnings: income from continuing operations, also known GAAP (Generally Accepted Accounting Principles) and As Reported

We do not intend to debate which of these earnings measurements represent better reflections of a company's profitability.  However, we will emphatically state, that after decades of producing earnings and price correlated F.A.S.T. Graphs on individual companies, that the market places a higher correlation on price and earnings with operating earnings than it does with as reported earnings.  Therefore, our research tool calculates growth rates and earnings justified valuation lines based on operating earnings.

With the above in mind, and in the spirit of fairness, we have calculated the S&P 500 CAPE valuation based on the 10-year time period 12/31/2001 to 12/31/2010 using both operating earnings and as reported earnings.  We chose this time frame because it is the most recent completed 10-year period so all numbers are actual, therefore, no estimates are used.  We pulled both earnings numbers directly from the Standard & Poor's 500 index data.  Our calculations are as follows:

On an as reported basis, the 10-year average S&P 500 earnings would be $52.03, and by dividing that number into the S&P 500 price on 12/31/2010 of $1257.64, we came up with a CAPE of 24.17.  On an operating basis, the 10-year average S&P 500 earnings would be $64.41, and by dividing it into the same S&P 500 price we came up with a modified operating earnings CAPE of 19.5.  Both of these CAPE calculations are above the historical normal 16 PE ratio according to Prof. Shiller.

There are several important points to consider here.  First, this time frame includes the two recessions of 2001 and 2002.  Second, future S&P 500 earnings must fall to CAPE calculated $52.03 (an implicit forecast) in order to validate the overvaluation thesis behind them.  That would require an earnings drop in excess of 54%, which is more than even the great recession of 2008. Next, this calculation would only be relevant to an index investor.  Finally, this refers to an index that contains numerous cyclical stocks; however as we will later illustrate, not all S&P 500 stocks are cyclical in nature. 

The PE Ratio Based on Actual Earnings

The following earnings and price correlated graph on the S&P 500 was selected to illustrate valuation based on actual earnings.  There are two price earnings ratio lines that are drawn on the graph.  The blue line (normal PE ratio) represents the widely accepted normal PE ratio of 20 that applies to approximately the last 50 years.  The orange earnings justified valuation PE line represents the longer term historical PE ratio of 15, which is generally accepted as fair value for the average company and approximates the PE of 16 that Prof. Shiller embraces.  The starting year 1995 was chosen because it was the most recent year (excluding the recession of 2008) where the S&P 500 was actually fairly valued with a PE of 15.  The graph ends in 2010 because it is the last completed calendar year.

We believe that this graph provides a much more relevant depiction of valuation based on a clearer correlation between earnings and price.  By reviewing this graph, it becomes crystal clear that the S&P 500 has, as Prof. Shiller currently contends, been mostly overvalued since 1995.  The 20 PE ratio blue line is a trimmed average PE ratio where the highest and lowest PEs have been discarded. We believe this presents a clear picture of a major fallacy behind relying on statistical analysis. 

Although the 50-year PE of 20 calculates and validates the statistical calculation, from the graph, it is clear that the market has only occasionally traded at the 20 PE.  Over much of the time, the S&P 500 traded both, above and below, the statistical reference point.  Perhaps validating the old adage that statistics don't lie, but statisticians are darn liars.

However, we believe the real value that the following graphic provides the perspective investor is the lesson on the importance of valuation and earnings growth to shareholder returns.  This graphic shows that the S&P 500 was fairly valued with a PE ratio of 15 (price touched the orange earnings justified valuation line) at the beginning of 1995.  However, equally as importantly, the price also ended in calendar year 2010 at precisely the same fair value PE of 15.  Although there was a lot of overvaluation, and a couple of recessions in between, the earnings growth rate of the S&P 500 averaged 6.1%.

The 16-year performance results associated with the above earnings and price correlated graph of the S&P 500 establishes the importance of valuation and earnings growth.  The closing annualized rate of return of 6.4% correlates almost perfectly with the 6.1% earnings growth rate.  The additional $66,000 worth of dividends paid (assumed spent, not reinvested), kicks the total annualized return up to a respectable 7.9% (see red circle) per annum.  Attractive and fair valuation at both the beginning and the end of this time period validates sound investing practices.

The next graph covers the period 1992 to October 20, 2011.  The focal point should be the current absolute low valuation of the S&P 500 relative to the last 20 years.  The indicated fair value based on a 15 PE times the estimated operating earnings of $97.88 indicates fair year-end 2011 value of approximately 1470 (see flag on graph), which is approximately 23% higher than current.  In other words, on an absolute basis we believe the S&P 500 currently is 23% undervalued, not 30% overvalued.

The following estimated earnings and return calculator is based on Standard & Poor's own current estimate for calendar year 2011, followed by Bloomberg's estimates for fiscal year 2012 and 2013.  In a report published on October 7, 2011 on Bloomberg.com, Wendy Soong reported Bloomberg's earnings estimates for the S&P 500 in total and for each sector.  Bloomberg forecasts an 11.7% share weighted earnings growth in 2012 followed by 10.9% in 2013.

The following hypothetical estimated earnings and return calculator uses a $50 earnings estimate (approximate CAPE calculation) for the S&P 500 in calendar year 2010 based on the only practical outcome that would validate Prof. Shiller's CAPE calculations.  This would imply that the S&P 500 earnings would have to fall by more than 54% from Bloomberg's 2013 estimate.  Remember that CAPE does not provide a precise date, so calendar year 2014 was arbitrarily plugged in.  That would be a significantly greater collapse than the recession of calendar year 2001’s 30% drop, or than calendar year 2008’s 40% drop.

The real point being made, is that Prof. Shiller is forecasting future earnings with his calculations either intentionally or by proxy just like everyone else.  However, the major difference is that Prof. Shiller is simply using statistical references based on historical data going back to the 1800s.  Although many would disagree, we argue that recent economic history is much more relevant and representative than what the economy was like in the 1800s or early 1900s.  The productivity enhancements from technology alone, render the economies of a hundred plus years ago, incomparable to today’s, in our opinion.  

It can't be ruled out that earnings could drop by the magnitude that Prof. Shiller's calculations indicate.  However, as previously mentioned, we would like to see a specific date specified when this would occur.  We do believe that it's highly unlikely, and therefore, we are much more comfortable with Bloomberg's numbers. Of course, we acknowledge that many doom and gloomers do believe this is a likely future occurrence.  

A careful review of the 20-year historical earnings and price correlated graphs do show that the S&P 500 is cyclical, so anything is certainly possible. However, it is important to keep the threat of recession in perspective; they are often short-lived and eventually followed by higher earnings and ultimately higher stock prices.  Consequently, we believe a major problem with CAPE is its continuous implied forecast of falling earnings.  This can cause investors to miss years of future returns based on a fear of some unknown and only hypothetical event.

Why He Is Specifically Wrong

Therefore, the biggest problem that we have with mere statistical inferences like CAPE, are concerned with the potential danger they present to the investing public.  Inundated with dire warnings of another decade of very poor returns based on these mindless number crunching exercises, many investors are fleeing equities in favor of other, perhaps even uncharacteristically more risky, investments like long-term bonds when interest rates are at their lowest levels in decades.

What's unfortunate about this scenario is that after decades where stocks, at least as represented by the S&P 500, were truly overvalued, they have finally become attractive.  Therefore, at precisely a time when equities represent the best opportunity and the lowest risk profile that they have in decades, investors are afraid to own them thanks to academic exercises like CAPE.

A significant portion of our argument is based on the undeniable reality that not all stocks in the S&P 500 are cyclical.  And CAPE, as we believe we have clearly established, can only be relevant if cyclicality is present.  In other words, CAPE only makes sense if future earnings will be significantly lower than current earnings. If you average a steadily increasing series of numbers, the average will be lower than the last number in the series. Yet in truth, the last number, and typically the highest in the series is the current and more relevant number.

What follows are two specific examples of blue-chip dividend growth stocks that have proven to be very recession-resistant, or noncyclical, and are clearly trading at historically low valuations due to nothing other than unsubstantiated negative sentiment.  There are many other examples such as Procter & Gamble (PG), Johnson & Johnson (JNJ), Abbott Labs (ABT), Medtronic (MDT) and many others too numerous to mention that could also be reviewed.

Our first example is PepsiCo Inc. (PEP).  From the earnings and price correlated F.A.S.T. Graphs below it is clear that PepsiCo's earnings have steadily increased (the orange line) right through both the recessions of 2001 and 2008 (recessions shaded red).  Furthermore, it is also clear from the graph below that PepsiCo’s stock is trading at, and in fact, slightly below fair value for the first time since calendar year 1995.  This implies the opportunity to invest in this company at the lowest risk, with the highest yield and therefore perhaps best long-term opportunity in a long, long time.  We do not believe that investors should be afraid of investing in a blue-chip like PepsiCo at such a historically low valuation.

Our second example looks at Wal-Mart Stores, Inc. (WMT), a potentially faster growing recession-resistant company, over the same 1995 to October 10, 2011 time frame.  After becoming excessively overvalued over the period 1995 to year-end 1999, Wal-Mart's share price went sideways before finally reverting back to fair value by the end of September 2007.  Consequently, what had been a dangerously overvalued blue-chip company for many years, has finally and recently become an attractive investment opportunity.  Today's current undervaluation with a blended PE ratio below 13 represents an extraordinary opportunity to invest in this king of retailers, in our opinion.  Followers of CAPE would be denied this tremendous opportunity.

Our third example reviews Oracle Corp. (ORCL), a leading technology and above-average growth stock that also has an impeccable recession-resistant operating history.  But most importantly, in spite of their excellent record of earnings growth, Oracle’s shares are currently available at one of the lowest valuations in decades.  For the total return investor interested in growing their capital, it would be a travesty to be thwarted from investing in this great technology company by CAPE.

Even when Oracle Corp.'s performance is calculated under the backdrop of one of its lowest valuations in years, the following associated performance results illustrate its investment merit.  This is clearly, and factually, a significantly above-average business.

Conclusions

This is the first of what will be a series of articles arguing in favor of investing in and owning quality common stocks now and for the foreseeable future.  On an absolute basis, on real numbers precisely calculated, we believe that the markets in general are attractively valued today. The CAPE measurement used by Prof. Shiller is a hypothetical statistic with no precise time designation, only an assumption.  The F.A.S.T. Graphs™ S&P 500 graph calculation is a current fact. 

Therefore, we believe that some of our finest and highest quality businesses are currently priced at the best valuations that we've seen in many years.  Low valuations, like we see today, represent an excellent opportunity for investors.  As Warren Buffett has wisely advised:“Be fearful when others are greedy and greedy when others are fearful.” With so many people afraid today, there's a cornucopia of quality common stocks available.  This article highlighted but a few.

We will follow this article with a series of three articles dissecting the Dow Jones Industrial Average through the lens of our earnings and price correlated F.A.S.T. Graphs research tool.  Our objective is to clearly illustrate that it is always a market of stocks, rather than a stock market.  One of our greatest objections to statistical inferences such as CAPE, and even Modern Portfolio Theory (MPT), is their emphasis on generalities while simultaneously ignoring the more relevant specifics. 

Recently there have been many who are arguing against the ability or even desirability of stock selection as a viable strategy.  We believe they are wrong, that success leaves clues, and that discerning investors can make wise and sound decisions with the proper tools and disciplines. 

Disclosure:  Long PEP, ORCL, JNJ, PG, MDT, ABT at the time of writing. 

Disclaimer:
The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

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"Chuck - Thank you for your well thought out articles. I tend to be a visual type of person so I really appreciate the F.A.S.T. Graphs™ approach."


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