Legendary UPenn-Wharton finance professor Jeremy Siegel has a problem with a valuation ratio developed by legendary Yale economist Robert Shiller.
In a new piece for The Financial Times, Siegel goes after Shiller’s cyclically-adjusted price-earnings ratio (CAPE).
CAPE is calculated by taking the S&P 500 and dividing it by the average of 10 years worth of earnings. If the ratio is above the long-term average of around 16, the stock market is considered expensive.
Siegel first gives credit to the CAPE for being able to predict long-term stock market returns in the 1980s through the 2000s.
But he’s suspicious that the more recent CAPE reading may be biased by distorted low earnings numbers that are making the stock market look expensive. From the FT:
I believe the Cape ratio’s overly pessimistic predictions are based on biased earnings data. Changes in the accounting standards in the 1990s forced companies to charge large write-offs when assets they hold fall in price, but when assets rise in price they do not boost earnings unless the asset is sold. This change in earnings patterns is evident when comparing the cyclical behaviour of Standard and Poor’s earnings series with the after-tax profit series published in the National Income and Product Accounts (NIPA).
For the 2001-02 and 2007-09 recessions, S&P reported earnings dropped precipitously due to a few companies with huge write-offs, while NIPA earnings were more stable. Yet before 2000, the cyclical behaviour of the two series was similar. Downward biased S&P earnings send average 10-year earnings down and bias the Cape ratio upward. In fact, when NIPA profits are substituted for S&P reported earnings in the Cape model, the current market shows no overvaluation.
This is likely to generate a response from Shiller sooner or later.
Shiller made a name for himself by sharing the CAPE with the world in the first edition of his classic book Irrational Exuberance, which predicted the dotcom bubble and solidified the Yale economist as one of the smartest people in finance of all-time.
Siegel believes stocks remain attractive at current levels. He recently told CNBC that the Dow could hit 17,000 this year.
Read his entire piece at FT.com.
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