Sunday, April 20, 2014
Beware CAPE, it could be your undoing
The blogosphere has been slowly shifting from worrying about the tepid nature of the current recovery to biting its nails over the timing of the next downturn. Feeding its fears is Robert Shiller's cyclically-adjusted price earnings (CAPE) ratio, the elevated nature of which would seem to indicate that the fun can't go on (see chart below). I think the the CAPE is a crappy measure for measuring valuations and should be largely ignored.
The general idea behind CAPE is that there exists a long-term average price earnings ratio to which stock markets will eventually revert. In the 1970s and early 80s, markets were undervalued on an earnings basis relative to their 16.5x average, so purchases made sense. Now they are overvalued relative to their historical average, so sales would be appropriate.
I have two explanations for why CAPE is a crappy measure for determining the over or undervaluation of equity markets. These are both "money" reasons, meaning that they have a monetary basis. I discussed the first last year in Beyond Buffett: Liquidity Adjusted Equity Valuation. I'll briefly summarize my points from that post before launching my second swipe at CAPE.
In brief, CAPE ignores the changing moneyness of stocks, or their liquidity. Stocks provide owners with a flow of earnings, but they also throw off a non-pecuniary flow of liquidity services. These non-pecuniary services stem from an investor's expectation that they will be able to easily liquidate those shares in secondary markets. For example, should your roof start leaking, your IBM shares can be quickly sold, the proceeds used to hire a contractor to patch the leak. The more liquid the stock, the more easily it can be dispatched to resolve the various unexpected problems that arise in life. Since these uncertainty-shielding services are valuable, people will pay a premium to enjoy them, a liquidity premium developing. Illiquid stocks may take longer to sell, and therefore provide a smaller flow of uncertainty-shielding services, commanding commensurately smaller liquidity premia.
Anyone who uses CAPE as a model is implicitly assuming that investors only purchase a stock so that they can own its expected flow of earnings, not its flow of liquidity services. Put differently, the CAPE model sets the liquidity premium on stock to zero. Thus a user of CAPE will attribute any rise in the CAPE above its long term average to changes in investors' willingness to pay more for each dollar of earnings. But if we bring liquidity into the picture, a rise in CAPE above its long-term average could just as easily be the result of a technological improvements to stock market liquidity. If the typical S&P 500 stock is more liquid than it was a decade ago, then people will pay more to own the liquidity return associated with stock, and the price of the S&P 500 will rise independent of earnings. This doesn't mean that a stock is expensive. It only means that stock "does" more things for the investor than before, and trades at a deservedly higher price.
A strict interpretation of CAPE says that we are currently so far above the market's long term valuation range that we need a market crash to bring things back into line. But if we adopt a liquidity-adjusted view, the idea that there exists a long term average to which price earnings ratios need to fall is silly. Stocks today are not your grandfather's stocks. They have become evermore cash-like and will probably continue to evolve in that direction, a progressively larger liquidity premia over the decades arising as a result. If so, observed price earnings ratios are not destined to revert to mean, but have attained a new and justifiably higher plateau, and will continue to hit higher plateaus in the future.
The second reason I don't like CAPE is its failure to properly account for inflation. Shiller uses earnings as his denominator, but during inflationary periods like the late 1960s, 70, and early 80s, earnings were a terrible measure of the true financial health of a company. Inflation, combined with historical cost accounting, has the effect of creating "phantom" earnings. These phantom earnings are mere artifacts of accounting rules, yet firms have to pay very real taxes on these earnings. As inflation mounts, a firm's artificially accelerating tax bill robs them of the cash they need to fund operations and new projects.
What follows is a short explanation of this effect, but if you prefer a longer one, try my old post A stock portfolio is a bad hedge against inflation.
If inflation doubles, the standard view is that stock is a great inflation hedge since a firm's revenues and costs immediately adjust upwards, the real value of the bottom line staying unchanged. However, historical cost accounting impedes a fluid 1:1 inflation adjustment. First, the cost of goods sold line on a firm's income statement doesn't rise in line with inflation. Inventories are accounted for on a first in, first out basis, which means the prices used to compute costs of goods sold are stale prices, as yet unadjusted for the ravages of inflation. Secondly, the depreciation line item doesn't rise with inflation. Machinery and other equipment are depreciated based on the item's historical (and therefore stale) purchase price, not on the basis of the good's current inflated price.
Since neither cost of goods sold nor depreciation rise during the early stages of an inflation, the firm announces higher real pre-tax profits. However, the rosy picture provided by the accountants obscures the fact that the firm's true economic position has not changed one bit. As inflation accelerates, the effect on the firm's cash flow is neutral. The net quantity of cash flowing into the firm from its clients less the cash flowing out of it to suppliers rise together. If the firm must pay 20% more cash to purchase inventory, that rise is completely compensated by 20% more in cash receipts from clients.
While the firm's net cash inflows from clients less outflows to suppliers remain constant during the inflation, the firm will find itself incurring larger cash outflows due to taxes. Based on the firm's growing accounting profits, the firm faces a higher tax bill than it did prior to the inflation. The growing quantities of cash that leak away to the government as inflation accelerates mean that less cash is available to pay suppliers, expand operations, or add to dividends. Inflation has made shareholders worse off. Taken to the extreme, a wild inflation will force a firm to pay an increasingly large portion of its wealth to the tax man, eventually resulting in the firm's bankruptcy.
So in periods like the late 1960s, 70s, and early 80s, it made absolutely no sense to value companies on the basis of their earnings. This makes a mockery of the CAPE parable. According to CAPE, investors in the 1970s irrationally bid stock down to very low prices relative to earnings. A smart investor should have picked up shares at these low levels in anticipation of a reversion to the long term CAPE ratio, a bet that would eventually payoff in the 1980s bull market.
In reality, since such a large portion of the earnings during that era were phantom, or non-existent earnings, investors placed a large value discount on them, or only purchased stock at very low price to earnings ratios. Stocks weren't being undervalued, they were being properly valued as the terrible inflation hedges that they were.
Contra the CAPE parable, the 1980s bull market was not the eventual payoff to the patient few who invested in low PE stocks. Rather, the bull market has Paul Volker to thank for, as it was his inflation-reducing policies that saved stocks from their own Achilles' heel; the adverse mixture of rising prices and historical cost accounting. Terrible inflation hedges they may be, when the reverse happens—low and falling inflation—stocks become stellar investments, as the 1980s would bear out. As inflation withered, phantom profits disappeared and firms were no longer forced to pay undeservedly high taxes. The large discounts that had been applied to earnings during the inflationary period were steadily removed.
So the CAPE fails because it ignores two monetary phenomena. It does not properly adjust for liquidity, nor does it account for the illusory profits that are created during inflationary periods. Until the quants figure out how to create a CAPE measure that corrects for these monetary effects, throw the CAPE in the toilet.