“LEAVING CAPE TOWN”

There is no better title than Josh Brown’s post title of January 12 to express the capitulation of the CAPE Ratio (Shiller P/E) advocates.

When I wrote QUIBBLES on January 7, I was not aware that John Hussman was in fact reacting to a December 2013 post in Philosophical Economics. Josh Brown explains:

Over the last few months, there’s been a radical rethinking of the utility of CAPE and a huge battle has been taking place in the financial blogosphere as a result, sucking in nearly every thought leader and serious investment writer in the process. Jesse Livermore, a pseudonymous blogger writing at Philosophical Economics, has really blown the debate wide open, beginning with what I consider to be one of the most notable financial blogposts of 2013 (see Fixing the Shiller CAPE from December 13th).

Nobody should be surprised that after having totally missed the fourth longest and fifth most powerful bull market of the last 100 years, the bears draped into professor Shiller’s CAPE would decide to do a more thorough inspection of the fabric that made them so comfortable and confident during the past several years but which is making them feel totally naked now. Analytical help is also coming from many sources which, now that the evidence is so clear, are coming out of the closets to expose to the world the hidden flaws of the CAPE approach.

These are much more than mere quibbles.

Too bad for all the investors who missed this generational bull because of religious beliefs of these well mediatized disciples. Religions can often blind the smartest people, making them so confident that they possess the Truth that they see no reason to dig below the  surface to better understand the inner workings of their formula.

I don’t agree with each and every specific “flaws” now attributed to the CAPE, finding that the digging may be getting too “accountingly” complex. We should not get over-zealous and totally dismiss what is after all a valid valuation concept that may eventually, but not very soon, become useful again. I also don’t agree with al the ways and means by which the data could be “adjusted”. Once you take this path, there’s no ending.

The most important problems with the CAPE now being exposed are essentially the same one I have been mentioning for many years and detailed in my 2012 post The Shiller P/E: Alas, A Useless Friend:

  • “Reported earnings” are not as “pure” as people believe and are far from providing the long-term consistency that the CAPE advocates pretend.
  • Notwithstanding the above, one has to question the relevance of the CAPE considering that upon close analysis (some people finally objectively did this), its long-term helpfulness in investment decision making leaves a lot to be desired.

Funnily, another important flaw in the current readings of the CAPE remains elusive to everybody. It is important since it will impact the CAPE ratio for another 5 years. To repeat myself:

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?

It will be very interesting to see how the exodus from CAPE town will impact demand for equities. Can we expect that investors who up to now religiously refused to sin will get back into equities as they undrape? Some wavering CAPE priests have been preparing their followers for their possible defrocking in the advent of a market correction. In fact, some have already capitulated, conveniently blaming the central banks for rendering their religious beliefs useless, possibly just as these turncoats’ own business began to be impacted by their unfortunate asset mix of the past 5 years.

Interestingly, as a result, a new wave of cash-rich equity investors could prevent the still useful Rule of 20 to correct as much as during the previous two major corrections since 2009 when the S&P 500 Index fell 13% (2010) and 15% (2011) as the Rule of 20 P/E failed to cross the 20 level and retreated back to 15-16. You might want to read TAPERING…EQUITIES before betting too much on this possibility.

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Note: The link to Josh Brown’s post will lead you to several interesting articles on this fascinating matter if you have time for that.

 

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