The Reformed Borker (Bork Bork Bork!) - in detail, why CAPE is CRAP. It's a great article that goes into a lot of detail as to why CAPE is a meaningless measure.
Consider that the US stock market has spent more than 95% of the last quarter of a century above the level that CAPE would say is expensive relative to long-term historical valuations. In that time, the S&P has increased by more than 450%, from 330 in 1990 to over 1840 today. To say that a total market increase of this magnitude, and over this length of time, all occurred within the context of what one would term a historically “overvalued” condition simply means that this tool’s definition of “overvalued” is, in and of itself, incorrect.
That's the central point, and so I'd ask: can you make money trading on CAPE? Seems you can make more money ignoring it. If this is true, then the right thing to do is ignore it.
I have trouble with the idea that someone using 100 years of stock market data is somehow doing science or physics. Markets are not mechanistic systems, rather they are biological, comprised as they are of millions of human beings, not nuts and bolts or electrons and neutrons. We’ve only got three examples of a secular bear market and possibly we’re at the end of a fourth. Go show a sample size of four to an actual scientist. And then explain how, when the data was first collected, the entire public market was made up of railroad stocks, see what the response is.
This is so true that it's trivial, and therefore the best kind of true. Seriously: if your chart isn't even charting the same thing over time, you need to throw out that chart. We learned this in first-year physics at university.
And so my argument is not that the CAPE Ratio is useless – in fact, quite the opposite; it is among the best measures of long-term valuation mankind has yet devised for the complex adaptive system that is the stock market. Unfortunately, it is just that – a long-term and laggard measure of valuation, one of many, that doesn’t even come close to explaining what might come next.
I'd add that long-term averages don't tell you what to do this month; and lagging indicators only tell you where you've been. If you're discounting your leading indicators in order to worship a lagging indicator, you're purposefully sticking your head up your own ass.
changes in GAAP accounting have meant drastic differences in the way stock options are expensed and in the way that earnings losses are accounted for when acquisitions fail or assets become impaired. There are also cash-on-the-balance-sheet issues to be aware of, as well as the effects of dividend and stock repurchase plans. There are distinct changes in the way that profits are reported and that earnings are generated that come about as a result of legislation. These variables completely change the profitability regime from one decade to another.
There are also societal changes that impact the level of stock ownership across the nation, things like the advent of the 401(k) and the mass-proliferation of stock-based compensation. Today, some 30% of household net worth is invested in stocks, stock funds or other such vehicles. This is double the levels of forty years ago, in 1974 it was more like 15%. Today, 60% of US households currently participate in the stock market in some way, shape of form – a significantly higher percentage than in generations past. Given this fact, is it any wonder that valuations have trended higher thanks to a larger pool of participants? Or should we ignore that entirely?
Again, this addresses the problem of the long-term chart not even measuring the same thing over time. Accounting has changed, and the supply/demand profile of the market has changed.
By the way, before you suggest that US households need to cut their stock allocation back down to 15% before we're at a bottom, you should think about what the fuck kind of idiocy you're suggesting. Ask your dad (or grand-dad) how much net wealth he had in 1974. My dad had zero; he had a mortgage and his pay was miniscule (this was before the great Canada Post Labour War of the 1970s). If you want to go back to the peasant world of the 1970s, maybe you should move to some third-world country where the masses are still dirt-poor.
Households are never going back to the pre-1970s asset mix. Unless the Republicans totally destroy America and impoverish everyone.
But wait! There's more:
Then there are structural changes like the mix of companies contained in a given index. There are very few companies in the S&P 500 that comprised the original index when it was created in 1957. And there are entirely new industries that have sprung up that hadn’t existed years ago – software, semiconductors, mobile telephony and the like. These new industries carry with them inherently higher profit margins that, to the unionized industrial behemoths of the 20th century, would’ve seemed impossible. My friend Justin Golden notes that Facebook has 5,000 employees generating $7 billion in revenues and it’s got a market value of $140 billion – triple that of General Motors, which employs 200,000 people. In the late 1970′s heyday of GM, it employed 600,000 workers and generated $63 billion in sales. Why anyone believes that measures of profitability from one era to another are in any way comparable – or that mean reversion will automatically kick in at some point to smash them back together – is inconceivable.
The Technology sector is almost twenty percent of the S&P 500, one fifth, and the stocks it’s comprised of are exponentially more profitable than former leadership groups in the index. Software companies in the S&P carry net margins north of 20% while consumer staples (food, tobacco, beverages) companies sport margins of under 3%! For energy stocks it’s closer to 10% and for industrial goods manufacturers it’s 7%. And people are surprised that corporate profit margins have been high and trending higher since the advent of the web in the mid-1990′s. Where is the mystery?
Did your buddy the CAPE-worshipper tell you this? Of course not. Because he's talking out his ass. He's never bothered to look under the hood, so he has no clue what CAPE is.
I'll stop here before I quote the entirety of Josh's article. It's a stunning, utter, absolute, total, final rebuke of everyone who throws CAPE in your face.
Josh looked under the hood and learned what the word "CAPE" means. He understands that a chart has to measure the same object over time. These are two skills an analyst needs to demonstrate before I even start to pay attention to them.