Down Under Daily, 27 November 2013

CAPE Crusader
I think US equities look expensive, and are therefore likely to generate low returns over the medium term. The Graham-Dodd PE (or cycle-adjusted PE, aka CAPE) says US equities are dear. A few readers dont like the CAPE, for the following reasons: Objection #1: the CAPE assumes mean-reverting earnings or margins. Objection #2: the CAPE now includes the unlikely-to-be-repeated negative EPS of 2008. Yes, the current CAPE earnings base includes the unprecedented negative Q4 2008 EPS result. On a rolling four quarter basis, EPS fell a long-way below trend in 2009. However, this was payback for the exceptionally strong earnings of the prior cycle: in 2007 EPS was running the furthest above trend in a century (Exhibit 2). Those strong numbers are also in the current CAPE earnings base.
Exhibit 2
45
EPS INDEX [REAL TERMS]

The CAPE does not assume structural meanreversion. It smooths cycle variations by taking a 10 year average of (inflation-adjusted) earnings. Structural changes that affect the trend in earnings over more than 10 years are implicitly incorporated into the CAPE fair value. For example, the 10 year earnings base now incorporated into the US CAPE is far above historical averages (Exhibit 1).
Exhibit 1
6 5

The Bigger The Bubble The Bigger The Bust

INFLATION-ADJUSTED S&P 500 EPS 40 35 30 25 20 15 10 5 0 1880 1900 1920 1940 1960 1980 2000
HISTORICAL TREND GROWTH IN REAL EPS (1.6% PA) 41 115 41
NUMBERS ARE THE PERCENTAGE GAP BETWEEN ACTUAL AND TREND EPS

72 55

41

A Permanently Higher Plateau?

S&P 500 PROFIT SHARE OF GDP
10YR AVERAGE

% OF GDP

4 3 2 1 0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
* BASED ON TRAILING PE (GAAP EARNINGS) AND MKT CAP PRIOR LONG TERM AVERAGE

Source: Standard & Poors, Robert Shiller, BLS; Minack Advisors

The S&P is now on a CAPE of 24 based on earnings that are a far higher share of GDP than the long-run average which points to a real return, including dividends, of 2% per year over the medium term. But if earnings mean-revert implying that the sustainable earnings base is lower than the average of the past decade then the real CAPE is around 35. At that price equities typically have negative returns over the following decade.
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This is an important point: if you believe that current historically-high earnings can be sustained then US equities look very expensive. If you think that earnings will mean-revert (either as a share of GDP, or margins as a share of sales), then US equities are nose-bleed expensive.

Source: Standard & Poors, BEA, NBER; Minack Advisors

Objection #3: CAPE says equities are expensive, but other measures suggest they are cheap.

This is exactly what the CAPE is designed to do: smooth earnings to get a better sense of what is sustainable. Earnings at the peak of the last cycle were clearly unsustainable, a point confirmed by the losses reported at the trough. To remove the low numbers without also removing the high numbers is nonsense. It is likewise nonsense, in my view, to use operating earnings earnings before bad stuff as the denominator in a CAPE.

Really? Most measures of absolute equity value suggest that the US market is now very expensive relative to history. In Mondays note I showed the high correlation between the CAPE and the price/book ratio. P/B is now further above its longrun average than the CAPE. Exhibit 3 shows two further measures: market capitalisation/GDP and market value of equities to replacement value (Tobins Q). Both are at levels rarely seen before.

Exhibit 3
180 160 140

More Measures Showing Equities Are Expensive

US EQUITY VALUATION MEASURES
LATEST IS END-Q2 * NON-FARM NON-FINANCIAL CORPORATES. FED FLOW OF FUNDS SERIES ** NON-FARM NONFINANCIAL CORPORATES. MARKET VALUE OF EQUITY RELATIVE TO NET WORTH (VALUED AT MARKET/REPLACEMENT COST)

1.8 1.6 1.4 1.2

% OF GDP

120 100 80 60 40 20 0 1950 1960 1970 1980 1990

EQUITY CAP/GDP* TOBIN Q** (RHS)
AVERAGE (CAP/GDP)

0.8 0.6 0.4 0.2 0.0

RATIO

1.0

Objection #4: Lower dividend payout ratios affect the fair value CAPE.

are in a new era for equity valuation then it seems returns are likely to be mediocre, given the limited upside for earnings. If valuations do ultimately mean-revert, then returns will be very poor. If valuations and earnings mean-revert, then returns will likely be negative over the medium term.

2000

2010

Source: Federal Reserve, BEA, NBER; Minack Advisors

The only measures I know that suggest equities are not expensive they dont say cheap are the 12 month trailing and 12 month prospective PE ratios.
Exhibit 4
50 45 40 35
RATIO

Not Expensive (Compared To Recent Past)

S&P 500 PRICE-EARNINGS RATIO
TRAILING PE FORWARD PE
Average post '85 (23.7) Average ex-09 is 21.6 Q3 09 PE was 140

30 25 20 15 10 5 0 1870 1890

Average pre '85 (13.7)

Average forward PE (14.9)

1910

1930

1950

1970

1990

2010

EPS GROWTH 30YR AVG %

Put another way, the only way that the current trailing or prospective PE ratios appear not expensive is to compare them to the recent past which includes the most expensive period of US equity valuation in history. Looking ahead, if we
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One (of several) problem with the prospective PE is that the series started in the mid-1980s. Every valuation measure with a long history says that the period since 1985 saw exceptionally high equity valuations. To use the average valuation since 1985 as an estimate of fair-value is to assume that that historically abnormal period is the new normal. The trailing PE illustrates this problem. The trailing PE is now around 19. This is below the average since 1985 of 23.7 (and below the average since 1985 excluding 2009, of 21.6). However, it is significantly above the pre-1985 average of 13.7.

Source: IBES/DataStream, Standard & Poors, Robert Shiller, Minack Advisors

To be fair, there may be a partial offset if the reduced payout ratio is used to increase share buybacks. However, in practice this offset is only partial: the increase in buy-backs (and the resultant EPS accretion) is small compared to the decline in the payout ratio. Another theoretical offset is if the lower payout ratio points to higher future EPS growth. If true this would (partially) offset the detrimental valuation impact of delaying the dividend stream. In practice, however, there is little or no correlation between payout ratios and EPS growth. Exhibit 5 shows the correlation over 30 years for a range of markets. Perversely, higher payout markets saw faster EPS. (Note, however, the very low R-squared, so the correlation is weak.)
Exhibit 5
12 10 8 6 4 2 0
DATA ON 23 MARKETS FOR 30YR CORRELATION.

Yes, this point is in principle correct. The bedrock of most equity valuation techniques is simple: assess the current value (NPV) of the expected flow of dividends. Consequently, the trend decline in corporate pay-out ratios in the US implies that, all else equal, the fair value CAPE is lower now than in the past. In short, adjusting valuation measures for the declining payout ratio would make the US equity market is more expensive relative to history.

No Correlation Between Payout And EPS Growth

PAYOUT RATIO AND EPS GROWTH, PAST 30 YEARS

R = 0.0716

20

40 60 PAYOUT RATIO 30YR AVERAGE %

80

100

Source: MSCI, Minack Advisors

Objection #5: Equities may be expensive, but the alternatives are worse. Yes, that may be true if investors are restricted to US asset markets. As I noted on Monday, however, the prospective return on US equities compared to US Treasuries is positive, but barely ahead of the excess returns investors usually expect.

Exhibit 6

CAPE By Market
GRAHAM-DODD PE RATIOS
Japan Index Switzerland Index United States Index DM MSCI Sweden Index Canada Index India Index Germany Index Australia Index United Kingdom Index China Index France Index Hong Kong Index EM MSCI Italy Index Spain Index Portugal Index Ireland Index Greece Index MSCI INDICES

The value in equities is outside the US, in my view. Exhibit 6 shows Graham-Dodd PEs (CAPE) for a range of markets. (Ive used MSCI indices and operating earnings, hence the US CAPE is lower than for the S&P.) I continue to think that if global growth is reasonable next year Im not sure it will be then the best place for an equity investor will be emerging markets and the periphery of Europe.

YEAR AGO NOW

8 10 12 14 16 GRAHAM-DODD PE

18

20

22

24

Source: MSCI, national sources (for CPI); Minack Advisors

Minack Advisors
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