Down Under Daily, 27 November 2013

CAPE CrusaderI think US equities look expensive, and are therefore likely to generate low returns over the medium term. The Graham-Dodd PE (or cycle-adjusted PE, aka CAPE) says US equities are dear. A few readers don’t like the CAPE, for the following reasons:

Objection #1: the CAPE assumes mean-reverting earnings or margins.

The CAPE does not assume structural mean-reversion. It smooths cycle variations by taking a 10 year average of (inflation-adjusted) earnings. Structural changes that affect the trend in earnings over more than 10 years are implicitly incorporated into the CAPE ‘fair value’. For example, the 10 year earnings base now incorporated into the US CAPE is far above historical averages (Exhibit 1).

Exhibit 1

A Permanently Higher Plateau?

Source: Standard & Poor’s, BEA, NBER; Minack Advisors

This is an important point: if you believe that current historically-high earnings can be sustained then US equities look very expensive. If you think that earnings will mean-revert (either as a share of GDP, or margins as a share of sales), then US equities are nose-bleed expensive.

The S&P is now on a CAPE of 24½ – based on earnings that are a far higher share of GDP than the long-run average – which points to a real return, including dividends, of 2% per year over the medium term. But if earnings mean-revert – implying that the sustainable earnings base is lower than the average of the past decade – then the ‘real’ CAPE is around 35. At that price equities typically have negative returns over the following decade.

Objection #2: the CAPE now includes the unlikely-to-be-repeated negative EPS of 2008.

Yes, the current CAPE earnings base includes the unprecedented negative Q4 2008 EPS result. On a rolling four quarter basis, EPS fell a long-way below trend in 2009. However, this was payback for the exceptionally strong earnings of the prior cycle: in 2007 EPS was running the furthest above trend in a century (Exhibit 2). Those strong numbers are also in the current CAPE earnings base.

Exhibit 2 The Bigger The Bubble The Bigger The Bust

Source: Standard & Poor’s, Robert Shiller, BLS; Minack Advisors

This is exactly what the CAPE is designed to do: smooth earnings to get a better sense of what is sustainable. Earnings at the peak of the last cycle were clearly unsustainable, a point confirmed by the losses reported at the trough. To remove the low numbers without also removing the high numbers is nonsense. It is likewise nonsense, in my view, to use operating earnings – ‘earnings before bad stuff’ – as the denominator in a CAPE.

Objection #3: CAPE says equities are expensive, but other measures suggest they are cheap.

Really? Most measures of absolute equity value suggest that the US market is now very expensive relative to history. In Monday’s note I showed the high correlation between the CAPE and the price/book ratio. P/B is now further above its long-run average than the CAPE. Exhibit 3 shows two further measures: market capitalisation/GDP and market value of equities to replacement value (Tobin’s Q). Both are at levels rarely seen before.

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19501955196019651970197519801985199019952000200520102015

% O

F G

DP

S&P 500 PROFIT SHARE OF GDP

* BASED ON TRAILING PE (GAAP EARNINGS) AND MKT CAP

10YR AVERAGE

PRIOR LONG TERM AVERAGE

11541

41

41

7255

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1880 1900 1920 1940 1960 1980 2000

EPS I

ND

EX [

REA

L TE

RM

S]

INFLATION-ADJUSTED S&P 500 EPS

NUMBERS ARE THE PERCENTAGE GAP BETWEEN ACTUAL AND TREND EPS

HISTORICAL TREND GROWTH IN REAL EPS (1.6% PA)

Page 1 of 3 Wednesday, 27 November 2013

Exhibit 3 More Measures Showing Equities Are Expensive

Source: Federal Reserve, BEA, NBER; Minack Advisors

The only measures I know that suggest equities are not expensive – they don’t say ‘cheap’ – are the 12 month trailing and 12 month prospective PE ratios.

Exhibit 4 Not Expensive (Compared To Recent Past)

Source: IBES/DataStream, Standard & Poor’s, Robert Shiller, Minack Advisors

One (of several) problem with the prospective PE is that the series started in the mid-1980s. Every valuation measure with a long history says that the period since 1985 saw exceptionally high equity valuations. To use the average valuation since 1985 as an estimate of ‘fair-value’ is to assume that that historically abnormal period is the new normal. The trailing PE illustrates this problem. The trailing PE is now around 19. This is below the average since 1985 of 23.7 (and below the average since 1985 excluding 2009, of 21.6). However, it is significantly above the pre-1985 average of 13.7.

Put another way, the only way that the current trailing or prospective PE ratios appear not expensive is to compare them to the recent past which includes the most expensive period of US equity valuation in history. Looking ahead, if we

are in a new era for equity valuation then it seems returns are likely to be mediocre, given the limited upside for earnings. If valuations do ultimately mean-revert, then returns will be very poor. If valuations and earnings mean-revert, then returns will likely be negative over the medium term.

Objection #4: Lower dividend payout ratios affect the ‘fair value’ CAPE.

Yes, this point is in principle correct. The bedrock of most equity valuation techniques is simple: assess the current value (NPV) of the expected flow of dividends. Consequently, the trend decline in corporate pay-out ratios in the US implies that, all else equal, the fair value CAPE is lower now than in the past. In short, adjusting valuation measures for the declining payout ratio would make the US equity market is more expensive relative to history.

To be fair, there may be a partial offset if the reduced payout ratio is used to increase share buy-backs. However, in practice this offset is only partial: the increase in buy-backs (and the resultant EPS accretion) is small compared to the decline in the payout ratio. Another theoretical offset is if the lower payout ratio points to higher future EPS growth. If true this would (partially) offset the detrimental valuation impact of delaying the dividend stream. In practice, however, there is little or no correlation between payout ratios and EPS growth. Exhibit 5 shows the correlation over 30 years for a range of markets. Perversely, higher payout markets saw faster EPS. (Note, however, the very low R-squared, so the correlation is weak.)

Exhibit 5 No Correlation Between Payout And EPS Growth

Source: MSCI, Minack Advisors

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1950 1960 1970 1980 1990 2000 2010

RATI

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% O

F G

DP

US EQUITY VALUATION MEASURES

EQUITY CAP/GDP*

TOBIN Q** (RHS)

* NON-FARM NON-FINANCIAL CORPORATES. FED FLOW OF FUNDS SERIES ** NON-FARM NON-FINANCIAL CORPORATES. MARKET VALUE OF EQUITY RELATIVE TO NET WORTH (VALUED AT MARKET/REPLACEMENT COST)

AVERAGE (CAP/GDP)

LATEST IS END-Q2

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1870 1890 1910 1930 1950 1970 1990 2010

RATI

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S&P 500 PRICE-EARNINGS RATIO

TRAILING PEFORWARD PE

Average pre '85 (13.7)

Average post '85 (23.7)

Average ex-09 is 21.6

Average forward PE (14.9)

Q3 09 PE was 140

R² = 0.07160

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EPS G

RO

WTH

30Y

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PAYOUT RATIO 30YR AVERAGE %

PAYOUT RATIO AND EPS GROWTH, PAST 30 YEARS

DATA ON 23 MARKETS FOR 30YR CORRELATION.

Page 2 of 3 Wednesday, 27 November 2013

Objection #5: Equities may be expensive, but the alternatives are worse.

Yes, that may be true – if investors are restricted to US asset markets. As I noted on Monday, however, the prospective return on US equities compared to US Treasuries is positive, but barely ahead of the excess returns investors usually expect.

The value in equities is outside the US, in my view. Exhibit 6 shows Graham-Dodd PEs (CAPE) for a range of markets. (I’ve used MSCI indices and operating earnings, hence the US CAPE is lower than for the S&P.) I continue to think that if global growth is reasonable next year – I’m not sure it will be – then the best place for an equity investor will be emerging markets and the periphery of Europe.

Exhibit 6 CAPE By Market

Source: MSCI, national sources (for CPI); Minack Advisors

Minack Advisors Level 8, 167 Macquarie Street, Sydney NSW 2000, Australia gerard@minackadvisors.com www.minackadvisors.com Authorised Representative No. 443937 Minack Advisors Pty. Ltd. ABN: 84 163 503 044

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EM MSCI

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United Kingdom Index

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Germany Index

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DM MSCI

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Page 3 of 3 Wednesday, 27 November 2013