QUIBBLES

(…) define “overvalued” as a Shiller P/E anything higher than 18 (given an actual multiple of 25.7 here, any objections to the Shiller metric are quibbles)

This quote from John Hussman’s Jan. 6, 2014 comment Confidence Abounds made me screech. In December 2012, Cliff Asness wrote something similar,

Those who say the Shiller P/E is currently “broken” have been knocked out.

in his well publicised piece An Old Friend: The Shiller P/E which triggered my own The Shiller P/E: Alas, A Useless Friend.

Pardon my quibbling with such trivial issues:

  • During Q4 2008, 140 S&P 500 companies, nearly 1 in 3, reported losses, 97 of which also recorded “operating” losses per S&P.
  • As a result of the carnage, trailing 12-month earnings for the S&P 500 Index collapsed to a trough of $6.86 in March 2009, down 92% from their June 2007 peak of $84.02.
  • A very large part of the losses were in financial companies due to the collapsing housing market and the Lehman failure. Many companies recorded humongous losses while their stock price sank as bankruptcy loomed. This extraordinarily unique combination of sky-high losses and stock prices diving towards zero created a very unique situation for stock indices: companies with then almost negligible market weights were recording humongous losses.
  • Incidentally, the S&P Financial sub-index recorded “operating” losses in each and every quarter of 2008 for a yearly total of $21.24 ($37.96 “as reported”).
  • Many of the companies that recorded huge losses in 2008-09 either went bankrupt or were substantially restructured or acquired. As a result, a conceptually valid valuation method such as the Shiller PE, measuring 10-year average earnings against a current index, is thus including in its denominator, during 10 years, the huge losses recorded by companies that are no longer included in its numerator, these companies having in fact been replaced by other, profitable, companies.
  • Humongous or very large losses were recorded in 2008 by companies such as AIG, GM, Merrill Lynch, Marshall & Ilsley, MBIA, Wachovia, all companies then part of the S&P 500 Index but no longer. Their losses still impact the 10 year average earnings even though they have no contribution to the actual index value. The losers are long gone but their losses remain!
  • This is like assessing a baseball team’s current batting line-up using 10-year data that includes the dismal stats of now deceased players. How useful is that?

The P/E10 concept is designed to take into account the economic cyclicality of earnings, particularly with regard to profit margins. In a sense, it is a way to normalize profits and thus normalize P/Es. This is just fine until we face a highly unusual situation like the 2007-08 financial crisis which, in addition to its cyclical impact, created a statistical depression on Index earnings that rendered their reading misleading for the reasons listed above.

The statistical cratering of S&P 500 Index earnings from $84.92 in June 2007 to $6.86 in March 2009 will weigh uninterrupted and un-weighted on the Shiller P/E for another 5 years, even though the many of the companies responsible for the crater are no longer part of the Index.

Blindly reading the high P/E10 stats can be dangerous to your financial health, like it has during the last 5 years.

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That said, John’s comment is worth reading in its entirety, if only to realize that volatility remains an inherent part of equity markets. This is especially true when monetary policy changes direction and when interest rates rise. The gradual starvation of financial heroin coupled with upward trending market interest rates will create headwinds that will need pretty strong earnings reports for equities to keep roaring ahead almost unperturbed like in 2013.

As an alternative to the Shiller P/E valuation tool, the Rule of 20 remains as valid and useful as before. It will be interesting to see if what John Hussman describes as the current state of “overbullishness” results in the Rule of 20 P/E finally crossing the “20 fair value line” into overvalued territory. Continued tame inflation numbers coupled with a good Q413 earnings season could do the trick during the next several months which are statistically favourable to equities as Doug Short’s chart below shows.

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4 thoughts on “QUIBBLES

  1. If the earnings results of the financials during the crisis creates a bias in the CAPE, is it not just an offset for pre- and post crisis biases to the upside? For a number of years post crisis much of the earnings reported by financials were the release of reserves taken because of the crisis. Additionally, the financial earnings pre-crisis were overstated because they did not accurately account for the poor underwriting. You can always find one time events in a series like earnings and frequently there is going to be an unseen offset…..

    • Good points Jack but the losses were much, much bigger than the recorded profits prior to the crisis. Also, my main point is that the companies that created the humongous losses are no longer part of the Index which still includes their results.

  2. With interest rates at such artificially low levels it’s almost impossible to calculate an appropriate PE multiple for this market. Shiller’s CAPE may yet turn out to out to have been the best measure because even if one removes the very low values recorded during the recession and afterwards, the CAPE is still in the low 20s which suggests that the market is well above fair value. Denis, I guess you saw Hester’s defence of the CAPE at http://hussmanfunds.com/rsi/cape.htm so I’ll say no more about it, but I do think that when interest rates eventually rise, the market will be seen to have gone up too far too fast and this will all end in tears.

    • Bill Hester did a fine job defending the CAPE although I maintain that the “deceased losers” continue to mislead this otherwise valid valuation tool. Nobody has addressed the fact that the companies that recorded the huge losses, operating and non-operating, are no longer part of the Index that still serves as the numerator. As to the debate on “operating” and “as reported”, I discussed that in The Shiller P/E: Alas, A Useless Friend. The best is to understand the pros and the cons of every method and use common sense without being dogmatic.

      Chris, if you remove the very low values recorded during the recession and afterwards, you cannot claim that the low 20s reading suggests that the market is well above fair value. In effect, you have thus meaningfully changed the time frame. You cannot compare the result of a 5y period with a historical 10y avg. which in effect tends to lower average multiples. The only way to modify the CAPE for this rather unique flaw would be to normalize 2007-09 earnings but then we would get into another endless debate.

      Regards.

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