In a recent Investor Newsletter, Scott Barlow suggested that value investing no longer works and turned to research by Morgan Stanley consultant Michael Mauboussin for an explanation. The theory is that many modern companies no longer invest in bricks-and-mortar assets, which are depreciated over time, but invest in intangible assets which are immediately expensed and therefore depress reported earnings. As a result, relying on traditional price/earnings ratios creates the impression that these stocks are dramatically overpriced and to be avoided by value investors.
This has been a recurring theme in professional commentary for some time, encouraged by the low-interest-rate environment which legitimately supports higher valuations. Lower rates used to value future cash flows will raise the price of any investment, other things being equal. This is particularly true in the case of attempts to value the overall stock market where there is usually some consensus on the earnings trajectory. The contentious issue is how much to pay for those earnings.
One popular price-to-earnings benchmark to determine valuations has been the Shiller CAPE ratio, named after Nobel prize-winning economist Robert Shiller. The computation is quite straightforward: Take the trailing 10 years of earnings for the index, deflate them to remove the impact of inflation, and then calculate the 10-year average earnings. This is the denominator and today’s index value is the numerator. A lower CAPE ratio denotes a more attractive stock market for the value investor.
The intent of using the 10-year time frame is to smooth out the fluctuations in earnings created by the business cycle, inflation and any other aberrations, such as COVID, and arrive at a normalized long-term price/earnings ratio. This number can be used to establish “fair value” for the market index.
But is the CAPE ratio as it stands still one of the best tools for value investors to seek earnings, or does it need revisiting?
The CAPE ratio was introduced in 1988 and it has been calculated in the United States as far back as 1881. According to an article by Mr. Shiller in late 2020, the average for the U.S. market over this entire time frame has been 17, while the more recent 20-year history has seen a reading of 25.6. Mr. Shiller concedes that “as U.S. interest rates have never been this low, we posit that these low rates have something to do with the elevated CAPE ratio.” In spite of this, some portfolio strategists continue to express alarm at the fact that the current CAPE ratio of about 34 puts it above the 90th percentile of its recorded history and that the market is due for a correction.
Which brings us to one reason why value investors have been left in the dust: an unhealthy obsession with these long-term ratios and the assumption that the valuation of the stock market will mean-revert, or return to its longer-term average.
This topic is covered in an article by Chartered Financial Analyst Marc Fandetti in the latest Enterprising Investor blog published by the CFA Institute. He points out that the CAPE ratio was essentially trendless for most of its history since 1900, so it was reasonable to assume that a high ratio would be followed by compression. There was in fact a strong negative correlation (-0.7) between a high CAPE ratio and the subsequent 10-year return from large-cap stocks, confirming the wisdom of reducing exposure to the equity market when the ratio is high.
All of this changed in the early nineties. Using a statistical test which is beyond my expertise, the Quandt Likelihood Ratio test, Mr. Fandetti demonstrates that the break point occurred in August, 1991. That degree of precision is perhaps unnecessary for our purposes: all we need to know is that after 1991, the CAPE ratio no longer has a tendency to mean-revert. In other words, waiting for a market collapse based on a downdraft in the CAPE ratio has left many value investors on the sidelines.
To be fair, Mr. Shiller followed up on his observation about low interest rates and the impact on the CAPE ratio in his 2020 article. At the time, interest rates were extremely depressed because the COVID pandemic was still in full force, so he suggested that the CAPE ratio be inverted (by dividing earnings-per-share by the market-price-per share) to create a 10-year average real earnings yield. From this he deducts the 10-year real interest rate to derive the excess CAPE yield. This is a metric that may more accurately reflect current valuations.
If you cast your mind back to late 2020, you will recall that several countries had negative interest rates at the time and the yield on 10-year U.S. Treasuries was less than 80 basis points. As a result, although the CAPE ratio was high (and the earnings yield was low), stock markets were seen as attractively priced because of a large spread between the two.
Britain was the biggest bargain with an excess yield of 10 percentage points, Europe and Japan came in at around six percentage points, while the U.S. trailed at a little below five percentage points. In my opinion, it is difficult to derive meaningful conclusions from this period of economic history. At a time of negative interest rates, any appreciating asset becomes wildly attractive – as urban house buyers will confirm.
With all that as background, there is a lot to be said in favour of the recalibration suggested by Mr. Shiller to take into account the impact of prevailing interest rates on establishing market values. The U.S. CAPE ratio is currently about 34, which generates a real earnings yield of 3 per cent, while 10-year U.S. government bonds have a nominal yield of 4.65 per cent. With inflation running at 2.7 per cent over the past 10 years and the year-over-year rate a little higher at 3.5 per cent, the adjusted real yield is in the range of 1 per cent to 2 per cent. This leaves the U.S. equity market with a Shiller excess CAPE yield of one to two percentage points.
Looking back at the Shiller excess yield chart over the past 40 years suggests that the U.S. market is at best fair value. It is a long way from the negative reading of the late nineties during the dot-com bubble but well short of the seven-percentage point spread between U.S. government bonds and the excess CAPE yield enjoyed in the aftermath of the financial crisis in 2008. For value investors, the light is not yet flashing red, but if interest rates remain higher for longer or inflation subsides, this is a ratio to revisit and maybe respond.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.
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Robert Tattersall