Are US Equities Expensive or Not?: The Debate Over Shiller’s CAPE Ratio

There’s a debate on the pros/cons of using Robert Shiller’s CAPE (cyclically adjusted price earnings) ratio happening on the world wide web.  First of all, what it is: CAPE, or Shiller P/E, or P/E 10 Ratio “uses smoothed real earnings to eliminate the fluctuations in net income caused by variations in profit margins over a typical business cycle.”  Basically you take the annual EPS for an equity index like the S&P 500, adjust for inflation, find the average, then divide the current by the average to find the CAPE ratio.  Here’s the problem: the CAPE ratio is currently at about 26, which is significantly above its historical mid-teens average and therefore suggests US equities are expensive.  Here’s another problem: using the CAPE ratio, some argued that US equities were overvalued by 40% in October 2009, which, turns out, was not the case (roughly 77% return for the S&P 500 since then).  Josh Brown argues that CAPE is useless as a market timing tool as it is “incapable of incorporating the evolution in some of the most fundamental influencers (changes in accounting standards, increase in stock ownership by household, new industries with new valuations etc.) on stock prices and then recalibrating itself accordingly — which means that its ability to make even long-term predictions is in doubt as well.”  John Hussman argues that CAPE may not be perfect, but the evidence speaks for itself: the CAPE ratio has correlated with real returns over 90% of the time since 1932.  The Financial Times sums it all up as a debate about how the world works and “seems to be a mirror for any preexisting optimism or pessimism.”  Goldman Sachs may be in the pessimistic camp, saying that “US equities are expensive relative to their own longterm history, as well as that of other developed and emerging markets.”  But don’t worry, Goldman doesn’t see a bubble since 1) credit growth isn’t excessive, 2) flows into US stocks haven’t been excessive, 3) sentiment isn’t frothy and 4) implosion isn’t an option (official Goldman decree!).  Furthermore, in a real bubbly scenario, “there seems to be a hinge point where investors go from thinking about quantifying economic trade-offs to a kind of binary framework where anybody who disagrees with them is demonized.”  So are US equities expensive?  Relative to Euro, Japanese and Emerging Market equities, Yes.  Relative to their own historical average?  It seems as if we could be on the expensive side of the spectrum, but I would argue that we aren’t at that hinge point just yet.  Also, a lot of investors think the market is overdue for a healthy correction; ask and ye shall receive.

USA: Lawmakers Unveil Massive $1.1 Trillion Spending Bill in Bipartisan Compromise

Looks like we aren’t going to shutdown the government this time: “Congressional negotiators unveiled a $1.1 trillion funding bill late Monday that would ease sharp spending cuts known as the sequester while providing fresh cash for new priorities.”  There’s a lot of new stuff in the bill (cut in funding to Afghanistan, cuts to the TSA, no more incandescent lightbulbs in Obama’s office), but I thought this was interesting: “In response to allegations that the administration has been stockpiling ammunition for use by federal agents, the measure also requires Homeland Security to provide detailed reports on its purchase and use of ammunition.”  Could be an interesting report for ammunition stocks like Alliant Techsystems Inc (ATK).

Stigma: Federal Reserve Discount Window and Pawned Bentleys

Apparently borrowing from the Federal Reserve makes you look weak or something: “[Discount Window] stigma is generally defined as banks’ reluctance to approach the DW out of concerns that, if detected, depositors, creditors or analysts could interpret DW borrowing as a sign of financial weakness…The economic consequences of DW stigma may be particularly severe during financial crises, preventing the Fed from effectively disseminating liquidity when it is most needed.  In addition, a bank that delays accessing the DW may resort instead to costly alternatives (such as fire sales of assets), which may further weaken the bank and add to financial system instability.”  Meanwhile, high-value pawnshops aren’t struggling with any stigma: “That pawnshops exist to lend money to those who fall on hard times is either a necessary or unfortunate facet of life, depending on one’s point of view.  But how does someone who once had enough money to buy a $450,000 Mercedes McLaren end up pledging it as collateral for a $190,000 pawn loan at a monthly interest rate of 2.5 to 4 percent?”

Holiday Retail Sales Somewhat Muted

Consumers didn’t lose track of their budget this holiday season: “57% of consumers said they spent what they planned during the 2013 holiday season, a bit better than the 54% saying that in 2012.  Another 26% said they managed to spend less, while only 14% spent more than expected.”  Meanwhile, “retail sales ticked up 0.2% in December…big-ticket items that are generally considered staples of the holiday season weighed on the number.  Sales at electronic and appliance stores fell by 2.5%, and auto dealers saw a 1.9% drop.”

Eurozone Industrial Production Gains; Spanish GDP Continues Slow March Upwards

“Industrial production across the [Eurozone] in November rose at the fastest pace in three and a half years, an indication that the currency area’s economy likely grew for the third straight quarter as 2013 drew to a close.”  Meanwhile, “Spain’s economy likely grew 0.3% in the fourth quarter from the third, as the country’s dire unemployment picture showed signs of improving more quickly than previously expected.”

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