A Closer Look at CAPE

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Many of the value investment blogs have been complaining that the CAPE on the S&P 500 is outrageously high. Clearly, the index is no longer cheap, and when I checked two weeks ago, I was concerned to see that its median EV:sales was now above 3x. But neither am I convinced by some of the commentary on the extreme valuation of the CAPE.

Some investors share an optimistic belief that the new administration will

  1. spark the economy into a higher growth trajectory, on the back of the already significant increase in small business optimism;
  2. cut tax rates and provide a further boost to earnings
  3. implement infrastructure initiatives which will further prime the economy
  4. provide  further stimulus through Made in America initiatives

Many investors are torn between this optimism and their natural reluctance to chase an already long bull streak and an apparently highly expensive market. Many value investors in particular point to a CAPE which is extremely stretched by historical standards.

Source: 720 Global

I stress that I have no particular axe to grind here – I accept that the market is expensive, but I also acknowledge that there has been limited impact on earnings forecasts from higher SME confidence, stronger global PMI readings and the prospect of better economic growth; potentially more important, corporate tax cuts could have a significant impact on the S&P 500 earnings.

Assume for a moment that the consensus S&P earnings forecasts are accurate – they may of course be cut, and consensus numbers for 2017 are quite punchy; but they don’t have any tax benefits factored in, and there should be some reasonable earnings growth driven by an emergence from an industrial and energy recession.

The combination of earnings growth and the depressed earnings years of 2008/9 dropping out of the calculation should have a significant impact on the CAPE as shown in the chart. Clearly the earnings numbers may be too optimistic, but even if you assumed flat earnings, the CAPE would fall from 26x to 22x, as the earnings in 2018 would be c10% higher than now, as 08/09 drops out.

I am not claiming any new insight with this, and of course Shiller originally used a 10 year measure of earnings to ensure that he would always have an economic dip included. But it seems just about possible that we could get to 2018 without such an earnings dip ie no US recession, and the market might not then look quite as richly valued as it does today, at least on this measure.