The Shiller CAPE: Addressing the Responses

In this piece, I’m going to address three responses to my earlier piece on the Shiller CAPE. First, a response from Peter Atwater of Financial Insyghts.  Second, a response from John Rekenthaler of Morningstar.  Third, a response from Bill Hester of Hussman Funds.  Let me say at the outset that I greatly appreciate the attention that these well thought out and well written responses have brought to the Philosophical Economics blog.

A number of interesting questions will be explored.  The piece is long, so feel free to fast forward to any specific highlight that interest you:

  •  (#1) How did the last two recessions compare with the prior 12 recessions on NIPA profit, CPI, real GDP, and the obvious outlier: S&P 500 reported earnings?
  • (#2) How did Sears’ 1931 annual report, issued in the depth of the Great Depression, compare with its 2008 annual report, issued in the depth of the Great Recession?
  • (#3) Is the expensing of stock options and asset writedowns an accurate form of accounting? Or is it a form of double-counting that distorts the true earnings power of a corporation?
  • (#4) Why are S&P reported profits more volatile than NIPA profits?  Does the answer involve changes to accounting regulations, or does it involve changes to stock option compensation practices?  Do executives want the profits of their companies to be more volatile, given that volatility increases the value of their stock options?
  • (#5) Why are executives of large corporations averse to making real economic investments? Why do they prefer to distribute cash via dividends and share buybacks?  Why is the U.S. economy currently depressed?  What is the solution?
  • (#6) Are profit margins mean-reverting?  What causes them to rise and fall?  If they fall, what will the likely drivers be?  When in the cycle do reported company earnings typically fall?  Using history as a guide, what is the risk of a meaningful fall in EPS right now?
  • (#7) Is it reasonable to expect the Shiller CAPE to revert to past historical averages in the current environment?  Did valuation bears get lucky in 2008?  Will they get lucky again?  

Peter Atwater’s Response

In an article on Minyanville, Peter Atwater, president of Financial Insyghts and author of Moods and Markets, argues that accounting practices follow changes in social mood.  In good times, optimistic managers apply accounting standards in ways that overstate earnings, and in bad times, the opposite.  He claims that CAPE is important as a valuation metric because it cancels out these distortions.  He also suggests that CAPE is a useful check against the temptation to throw out the “old” rules, a temptation that investors tend to embrace at the worst possible times in the cycle.

I agree with Peter’s points.  The problem, in my view, is that changes in accounting regulations have significantly worsened what the “down” part of the cycle looks like relative to the past.  If we’re going to effectively use CAPE to conduct apples-to-apples valuation analysis, we need to address this distortion.

The following table shows the changes in earnings and other economic variables that occurred in each of the fourteen recessions from 1929 to 2013.  We take a period starting six months before the beginning of the recession, and ending six months after its termination.  For each period, we calculate (1) the change in S&P reported earnings from peak to trough, (2) the change in CPI that occurred alongside the reported earnings change, (3) the change in NIPA profits from peak to trough, and (4) the change in real GDP from peak to trough.


Take a moment to peruse the table.  Notice how extreme the plunges in reported earnings were in the last two recessions (2001, 2008) relative to earlier recessions, and relative to the concurrent changes in the other variables.  The 2001 recession was small, with only a tiny drop in NIPA profits and GDP–but reported earnings fell more than in any other recession outside of the Great Depression.  The economic downturn of 2008 was not especially extreme by historical standards–but earnings fell more than in the Great Depression.

Does it make sense that earnings would have contracted more in the 2008 recession than in the Great Depression (highlighted in green), a downturn that was 6 times as severe in real terms, 10 times as severe in nominal terms?  In the Great Depression, NIPA profits actually went negative.  They fell by more than 100%.  We can only imagine the earnings calamity that would have ensued if current accounting regulations had been in existence at the time: every intangible asset in the entire economy would have had to have been written down.

The fact that NIPA profits fell significantly more than S&P reported profits during the Great Depression suggests that public corporations were understating their losses to shareholders. The suggestion should come as no surprise–financial regulation and oversight of publicly-traded firms at the time was nothing like it is now.  For fun, compare Sears’ 1931 annual report to its 2008 annual report.  Which report do you think was more rigorous?  Which report do you think faced greater regulatory imposition and supervision? One was a friendly, fluffy 8 page letter from the Company President, with a few tables, the other was 104 pages of “risk factors”, “disclaimers” and “SFAS testing.”  Notice the $10MM in goodwill carried on the 1931 balance sheet.  We don’t know exactly what it entailed, as the company didn’t discuss it.  Under current accounting standards, it would have had to have been tested for impairment.  Given the company’s rapidly declining sales amid a deflating operating environment, there’s an excellent chance that it would not have passed.  If fully written down, it would have negated almost all of the company’s earnings for the year.

If S&P earnings in the Great Depression had been reported in accordance with current accounting regulations–to include current levels of rigor and oversight–then, at a minimum, they would have fallen by the same amount as NIPA profits, and probably by a an amount orders of magnitude larger, enough to “erase” years of prior earnings from the Shiller average.  The example would have served as an excellent operational disclaimer on CAPE: do not use after ugly downturns, lest you end up with distorted pictures of valuation.  Such a disclaimer would have been particularly useful in the early stages of the current bull market, when valuation bears were already aggressively citing CAPE as a reason to stay away.   

To summarize, there’s no question that corporate accounting follows trends in social mood. In good times, managers are overly “generous” with their results, in bad times, they are forced to “fess up.”  But changes to accounting regulations have dramatically amplified what the “fessing up” part looks like relative to the past.  Corporations are taking much bigger baths in downturns than they used to (#1#2#3, #4), for reasons directly traceable to the changes.  If we want the CAPE metric to be reliable going forward, we need to modify it to account for the difference.

John Rekenthaler’s Response

John Rekenthaler, Vice President of Research for Morningstar, agrees that the Shiller CAPE is flawed, but doubts that the proposed changes are sufficient to fix it.  He points out that even after the modifications, the metric fails to account for recent historical experience.  The modified metric was dramatically elevated in the mid-to-late 1990s and meaningfully elevated in the early-to-mid 2000s, yet the market went on to post strong subsequent returns–stronger than the metric would have otherwise predicted.

John is right.  Changes in accounting and dividend payout ratios are not in themselves sufficient to make the metric work in the current era.  That’s why in the last part of the piece I argued that we’ve reached a “permanently high plateau” in valuations, and that we need to shift the benchmark for the metric upwards.  John took issue with the phrasing “permanently high plateau”, preferring a more charitable allusion: a “new normal.”  Fair enough.  To be clear, I chose the phrasing somewhat facetiously, to mock the apparent “scandal” that ensues when people state the obvious: that “this time is different.” 

Not only is this time different, every time is different.  That’s why so many investors are able to outperform the market looking backwards, using curve-fitted rules and strategies. But when you take them out of their familiar historical data sets, and into the messiness of reality, where conditions change over time, the outperformance evaporates.  

The question is, in what way is this time different, relative to the ways that other times have been different?  With respect to the Shiller CAPE, the explanation doesn’t need to rest entirely on the notion that exogenous changes (structurally low inflation and interest rates, improved policymaker understanding and support of the economy, reduction in the risk of left tail events, an increase in retail access to the stock market, a better-informed class of investors that more efficiently identifies and collapses excessive risk premia that would have been left in the system in the past, changes in dividend and capital gains tax rates–and if you’re a bear, “the Greenspan-Bernanke-Yellen Put”) have produced a “new normal” for Shiller CAPE valuations.  There are additional, more mechanical changes in the metric that can be cited.

Bill Hester’s Response

Bill Hester, senior financial analyst at Hussman Funds, notes that the Bloomberg EPS series, which goes back to 1954, entails a splice between something approximating reported earnings before 1998, and something approximating operating earnings (as calculated by S&P) after 1998.  He argues that it’s unfair to the past to calculate the Shiller CAPE with the Bloomberg series, because operating earnings are persistently higher than reported earnings, by an average of around 30%.

It’s true that from the beginning of publication (1988), S&P’s operating earnings series has been on average around 30% higher than reported earnings.  But we obviously need to distinguish between the periods before and after the relevant accounting changes.  In the period before 2001, S&P’s operating earnings series was on average around 10% higher than reported earnings.  In the period after 2001, S&P’s operating earning series has been on average around 50% higher.  

To avoid any inconsistency in the Bloomberg series, we can boost the pre-1998 part of the data by the 10% average difference between S&P operating earnings and reported earnings observed in the pre-2001 period (before the accounting changes were instituted). After adjusting for dividend payout ratio changes, the S&P at 1775 (where the discussion started) goes from being roughly 13% above the 1954 to 2013 average, to being roughly 23% above that average (the average shifts up from the boost).  A fair adjustment–but small compared to the 60% overvaluation that we observe when we compare the unmodified Shiller CAPE to its 130 year average.  

(note: what follows here is a detailed accounting discussion–if you are not in the mood, feel free to fast forward)

One related issue that hasn’t yet been raised, but that could potentially create inconsistencies in the modified metric, pertains to the expensing of stock options.  In the past, corporations were not required to directly expense stock options.  The requirement was changed in FAS 123, issued in the mid 1990s, and then again in FAS 123R, issued in the mid 2000s.  Stock options now have to be deducted from earnings at “fair value” on the date of issuance, as calculated by an option pricing model.  The difference wouldn’t have made much of a difference in the past because stock options were not a common form of employee compensation.  But since the late 1980s, they’ve become substantially more common, and are now a meaningful expense for many corporations, especially “tech” companies.

The problem with the direct expensing of stock options is that it exaggerates their true cost, regardless of the option outcome.  Suppose that a corporation issues stock options to an executive.  Either the options will eventually expire worthless, or they’ll eventually be exercised.  If they expire worthless, then a FAS 123R “fair value” expense will have been charged against the company’s earnings even though the options never turned into an actual cost for the company.  If the options are exercised, then the share count will be diluted.  The cost of the option grant will show up in the form of reduced earnings per share.  But, also, in addition to the dilution cost, the “fair value” at issuance will have been deducted from earnings in a one-time event.  The cost will therefore be double-counted. Ultimately, the practice of direct stock option expensing is guaranteed to get the accounting wrong: it will either singly count costs that are never incurred, or it will doubly count costs that are only incurred once.

To be fair, even though stock option expensing understates earnings by double-counting the cost of share dilution, ignoring the expense altogether can lead to exaggerations in the Shiller CAPE, given that earnings are averaged over a ten year period.  The averaging has the potential to “water down” dilution events that occur towards the end of the period. To illustrate, suppose that a stock option is issued and exercised in year 10.  The reduced EPS will only show up in that year–none of the other years will be affected.  When the 10 years are averaged together, the effect of the dilution will end up being “watering down” to almost nothing.  Unless we go back and calculate the EPS for all of the prior years using the new, more recent share count, we won’t be able to capture the true cost of the option.  So we have to deduct it as an expense–and accept the double-counting penalty.  On the other extreme, if the option is issued and exercised in the beginning of the 10 year period, and we deduct it, then we suffer maximum double-counting effect.  Every year of the average will have the dilution in it, so it will be perfectly expensed, yet we will then deduct it from earnings again in a one-time chare.  

Fortunately, the operating earnings series calculated by S&P is normalized to ensure that both stock option expense and pension expense are included.  To be conservative, we can splice the S&P operating series after 1988 with a reported earnings series boosted by 10% before 1998 to create an optimal data set for Shiller evaluation. After adjusting for changes to the dividend payout ratio, the metric ends up showing the market as 25% more expensive than the 1954 to 2013 average, in comparison with the original 13%.

Bill goes on to challenge Jeremy Siegel’s proposal that the CAPE be calculated with NIPA profits instead of S&P reported earnings.  He points out that the two data series are significantly different from each other.  The NIPA series, for example, tracks the profits of roughly 9,000 public and non-public companies, many of which are tiny in comparison with the large caps of the S&P 500.  There is no per share adjustment, therefore there is no way to account for dilution.  Crucially, the series only tracks profits from current production–it doesn’t include capital gains and losses from merger and acquisition activity, or bad debt expenses.

But that’s part of the reason why it’s useful in this context.  To make apples-to-apples valuation comparisons, we need a standard that has been applied consistently across history.  The simpler NIPA standard meets this criteria, the complex, materially-evolving GAAP standard does not.  NIPA profits do not serve as a literal proxy for the reported EPS of S&P 500 companies, but they have the potential to provide a more accurate measure of the “overall” market’s valuation relative to the past.  They corroborate the conclusion that we reach when we calculate the metric with operating earnings: that the market is less expensive than the GAAP metric suggests.

Bill goes on to address the topic of writedowns, urging us to consider the topic in the context of the full economic cycle.  He points out that a write down in book equity typically occurs for one of two reasons: either profits already booked were overstated, or executives invested the firm’s money poorly.

At this point, it’s worth clarifying what is actually at issue when we talk about writedowns in the context of reported earnings versus operating earnings.  We know that S&P operating earnings exclude the writedown of goodwill and intangible assets.  The question is, what types of financial writedowns are excluded?  In particular, are writedowns of toxic, illiquid debt securities held and traded by banks excluded?

The answer appears to be no, that they are included.  There are a number of ways to arrive at this point.  The following shows writedowns by type for the S&P 500 for calender year 2008 (borrowed from an excellent KPMG report on the differences between European and US accounting), as well as the dollar difference between reported and earnings for the year:


The difference between reported and operating earnings for calendar year 2008 was around $300B.  Of that amount, we know that $220B, or 70%, came from impairment losses on goodwill and other intangible assets.  The other 30% would then have to be divided between writedowns to financial assets, property, plant, and equipment (PPE), and any other excluded charges that explain the difference.

We can infer that the writedown of financial assets was not the main contributor to the remaining 30% of this difference by examining reported and operating earnings for the financial sector, which S&P also publishes.  The majority of the losses that financials incurred in 2008 showed up in operating earnings.  For the entire year, the loss on operating earnings for the sector was $21.24, versus $37.96 on reported earnings (note that there were significant goodwill and intangible writedowns in the financial sector, which can account for the difference).  For the notoriously ugly 4Q of 2008, the loss on operating earnings was $13.93, versus $23.91 for reported.

Notably, the correlation between financial sector operating and reported earnings in the S&P series from 1Q 2008 to 3Q 2013 is the highest of any sector:

qtrly correl

A final quote from Andrew Hodge of the BEA lends further support to the inference: “S&P 500 operating earnings in the fourth quarter of 2008 turned down, to a loss of $0.8 billion from a gain of $87.8 billion in the third quarter. Although write-downs are excluded from the S&P 500 operating earnings measures, trading gains and losses are considered part of S&P 500 operating profits and losses, and a portion of these are likely capital losses on held positions rather than spread or market-making profits.”

When we talk about writedowns in the context of operating and reported earnings, then, we’re not talking about banks levering up on subprime CDOs and capturing an inflated spread during in a boom, and then requesting to have the subsequent mark to market and writedown losses removed from the earnings calculations during the ensuing bust.  There’s an argument to be made for excluding those losses–for example, contrary to common assumption, banks didn’t excessively contribute to profits growth during the boom, and during the bust they were forced to raise significant amounts of private and public capital to offset their losses, which created large dilution.  They were a genuine outlier over the entire cycle–if we had removed them from the beginning and only looked at non-financials in the CAPE, the metric would likely have fared better.  But we don’t need to get into those arguments. The types of writedowns at issue here are primarily the writedowns of goodwill and intangible assets, with additional writedowns of PPE.

It’s important to remember that GAAP does not generally allow for “writeups” of assets in ways that would lead to the overstatement of earnings, so a corresponding writedown would not be necessary to undo the distortion.  Ironically, under the standard, even if an asset recovers its value after having been written down, it cannot be written back up.  The standard is extremely conservative.

The second purpose of writedowns that Bill cites is therefore the one that is most relevant here–accounting for the cost of poor investments of the firm’s money.  To that end, writedowns commit the same error that we saw in stock option expensing: they double count the true cost.  Let me explain.

A company can “return” profit to shareholders in one of two ways: directly, by paying dividends, or indirectly, by making investments that lead to an increase in future EPS (and therefore an increase in future dividends, and also an increase in share price, assuming a constant valuation).  If a corporation uses its prior earnings to make a failed acquisition, the “loss” of the prior earnings is already accounted for, as no associated dividends were ever paid, and no sustained EPS growth is present.  The best approach is to just move on–the loss of what “might have been” is already there.  GAAP accounting rules, however, require corporations to book a second loss, a writedown.  The writedown amounts to a “verbal” removal of past earnings that were already taken away by the fact that shareholders did not receive anything from them, and never will.

Granted, the book value may have gone up, but the book value is operationally meaningless in this context.  It has no impact on earnings-based valuation measures.  If we want the book value to go down to reflect the fact that prior earnings were wasted, then we should just reduce the book value in a separate action and move on.  There’s no need to distort the operating earnings picture in the process–it has already taken the hit via the lack of sustained growth.

The same is true of the writedown of acquisitions in which debt and share issuance are used to make the purchase.  The cost of the acquired entity is the added interest expense (from debt issuance) and the added dilution (from share issuance) that the purchase entails.  The benefit of the acquired entity is the earnings stream that it brings into the business.  If that earnings stream falls, such that the acquired entity needs to be written down, then the cost will be accounted for by the drop in EPS.  Subtractions to EPS (interest expense and dilution) were incurred without any offsetting gains.  That’s exactly where the “loss” lies.  A one-time deduction against future earnings will count it again.

We use the Shiller metric because we want to compare the current price of the corporate sector with its long-term, forward-looking earnings power.  Writedowns cause the metric to artificially understate that power, especially around recessions.  To illustrate, suppose that a company accumulates profit in its operating business over a ten year period.  It then uses the entirety of the accumulated profit to make a bogus acquisition that it eventually fully writes off.  Do we want the Shiller CAPE to show the company as worthless, because the sum of its ten year earnings, to include the writedown, equals zero?  Of course not.  As prospective investors, we’re concerned with what the operating business will produce for shareholders going forward–a failed past acquisition is irrelevant to that consideration.

Of course, pessimists will argue that writedowns should be counted because imprudent acquisitions are a systematic feature of corporate behavior.  But before they make this argument, they need to consider the many successes that occur alongside the failures–the multitude of acquisitions that prove to be accretive, synergistic, even brilliant, and that boost long-term returns for shareholders.  The “gains” of these acquisitions are accounted for in the EPS accretion that they produce.  Notice that we don’t count them twice in a “write up.”  But if we’re going to count the mistakes twice, shouldn’t we do the same for the successes?  The end result, of course, would be a cancellation–no different than if we just ignored writedowns altogether, which is exactly what the modified metric proposes that we do.

To summarize, writedowns create three distortions in the Shiller CAPE.  First, GAAP regulations affecting writedowns are not consistent across time–they changed dramatically in the early 2000s, penalizing the current period in comparison to the past. Second, writedowns involve double counting.  The “loss” to shareholders of prior earnings is already accounted for in the fact that the earnings were not connected to a dividend payment and did not produce sustained EPS growth.  The “loss” that occurs when debt and equity are used to fund a failed purchase show up via reduced EPS from the added interest expense and dilution.  Counting the “loss” in a one-time charge double-counts it, and therefore unfairly penalizes the metric.  Third, to count writedowns is to tell only one side of the story, since corresponding “writeups” are never counted.  Valuation bears would go insane if companies were allowed to artificially jack up their profits and depress the index P/E by “writing up” the goodwill of accretive acquisitions during good times.  Valuation bulls have an equivalent right to object when the same thing happens in reverse, during bad times.

Bill suggests that there is symmetry in the writedown process, that writedowns are akin to a giveback of prior earnings exaggerations in the cycle.  The point is complicated, so I’ll let him make it:

“While substituting NIPA profits for S&P EPS to calculate a P/E is inappropriate, we can use NIPA profits as a general proxy for economy-wide profits. In that way, we can judge the volatility of corporate earnings among publicly traded companies. The graph below normalizes NIPA corporate profits to the beginning value of Standard & Poor’s Reported EPS series a decade ago. We would expect company profits to be more volatile than NIPA because of the different way the two profits are recorded. This is clearly supported by the data. Corporate profits at the company level are much more volatile – and importantly, in both directions. Company-level earnings grew more quickly during the 2002 – 2007 expansion, but the collapse of those earnings was more dramatic during the recession. The average company-level EPS during this period is $64. The average normalized NIPA Profit was $62.”

The graph:


Notice that the blue line (reported earnings) rises well above the red line (NIPA profits normalized to reported earnings) during the 2003-2007 expansion, but then falls well below it during the 2007-2009 recession.  The implication is that in the “good” times, reported earnings grow more than they should (based on a comparison with NIPA profits), suggesting an exaggeration, and that in the bad times, the exaggeration is given back (via “justified” writedowns).  The giveback appears to bring reported earnings and NIPA profits into uniformity across the entire cycle.

But the graph is an illusion.  The starting point for normalization is 2003, a period of maximum goodwill writedown impact.  Trailing S&P reported earnings were $35, but actual operating earnings (which track NIPA profits more closely) were $49, a 40% difference.  It looks like reported earnings “grew” faster than NIPA profits from 2003 to 2007, in some kind of earnings “bubble”, but this perceived excess “growth” is just an artifact of the removal of large goodwill impairment charges.

Consider what the graph looks like when we normalize NIPA profits to S&P operating earnings instead of reported earnings:


The substantial “excess” growth seen from 2003 to 2007 goes away.  Note that unlike the previous graph, in this graph NIPA profits grow more over the entire period than S&P operating earnings, as they should over the long-term, given that they include the profits of small and medium-sized firms.

The following chart normalizes non-financial NIPA profits to S&P operating earnings:


We see that earnings exaggerations in the financial sector, an implied “culprit”, were not a key driver of earnings growth from 2003 to 2007.  The NIPA earnings growth is actually higher when they are taken out, including during the boom.

Finally, consider what Bill’s earlier graph looks like when when we shift the starting point back by a few years, so that we aren’t normalizing to the trough of writedown-depressed reported earnings.

spx reported earnings

Bill’s earlier claim that company level profits are significantly more volatile than NIPA profits–“importantly, in both directions”–loses its support.  The chart shows that they have become significantly more volatile in one direction (which then implies the other, upon the reversal).  The cause is clear: the impact of the accounting changes at issue, particularly around recessions.

Bill’s subsequent chart, inspired by the recent work of economist Andrew Smithers, confirms the point:


Smithers blames the rise in the blue line (reported EPS volatility) relative to the red line (NIPA profit volatility) on changes in executive compensation practices that have occurred over the last few decades.  But there is a far more compelling explanation available, an explanation that Smithers seems to have missed: that changes to accounting regulations pertaining to goodwill and other types of writedowns have fueled a significant increase in reported earnings volatility, particularly around recessions. Those changes were instituted abruptly around the first rise, 2001. Their impact exploded in the financial crisis.

Smithers argues that profits have become more volatile because stock option compensation incentivizes earnings volatility.   Bill explains Smithers’ argument:

“Smithers argues that with such a large portion of earnings tied to short-term performance, executives prefer volatile profits. Big gains lead to greater compensation. Big losses allow for the possibility of resetting strike prices lower.”

This argument doesn’t make sense.  If earnings have become volatile because executives prefer them to be volatile, given the implied increase in stock option value, then why do executives go to such lengths to emphasize to the market that losses fueled by writedowns are not real losses?  The way to create volatility is not to publish artificially depressed GAAP numbers and then tell the market why they don’t matter to the actual business, but to stand behind them, distortions and all, and let the stock price tank (so that the next round of options is awarded at a lower strike).

Put yourself in the shoes of a CEO right now.  Do you feel more confident making an acquisition knowing that if it ends up a disaster, the stock will fall, allowing you to scoop up options at low strike prices?  Does this absurd thought even enter your mind?  Of course not.  As the leader of a company, you don’t want to disappoint the people that rely on you, that have put their confidence in you.  You don’t want to have to get in front of the entire world on a conference call and explain why the company is underperforming.  You don’t want to have endure the stress and embarrassment.  Most importantly, you don’t want to lose the immensely lucrative, high-status job that you’ve earned.  Those considerations are infinitely more powerful in your mind than any ridiculous thought that you might have about the additional leverage that your subsequent stock option compensation will carry if things turn out poorly.  If you tarnish the company’s balance sheet with a bad acquisition, and your stock price falls, you won’t have a job, therefore there won’t be subsequent stock option compensation for you to worry about.  Ask Leo Apotheker of $HPQ.

Smithers has the story backwards.  What executives don’t want is earnings volatility. Higher volatility in earnings means higher volatility in stock prices, which means angry shareholders (on the way down), which means anxiety and insomnia amid the possibility of losing what you’ve worked your entire life for, becoming a “failure” in front of the people whose opinions dictate your sense of self-worth.

The increasing intrusion of Wall Street culture into corporate boardrooms, fueled in part by stock-flipping activists and a story-hungry financial media, has made executives more averse to risk-taking.  That aversion–not some perverse desire to set option strikes lower–is part of the reason why real economic investment on the part of large corporations is depressed, and why share buybacks are all the rage.  Real economic investment is the riskiest type of investment there is.  Share buybacks, in contrast, carry zero risk–the EPS goes up without any possibility of going down.  No one is ever going to criticize a CEO for engaging in them, especially in an environment such as the current one, where stocks are perceived to be cheap (or at least were perceived to be cheap, prior to the recent ramp).

Consider the example of $AAPL. Why is $AAPL not using its cash to make aggressive new investments?  Why is the company instead opting for a record-breaking $50 billion dollar share buyback program?  Is it because Tim Cook wants maximum volatility in $AAPL’s EPS?  Hardly.  It’s the opposite.  Tim Cook wants minimum earnings volatility, that’s why he buys back shares.  He doesn’t want to disappoint analyst estimates and send the stock price lower.  He has an entire country of spoiled shareholders ready to fire him if they don’t get the return they expect.  He therefore shies away from the kinds of aggressive investments that would put him at risk of big earnings misses–the kinds of investments that Jeff Bezos, founder of $AMZN, engages in (that actually do produce big earnings misses, but that also have the potential to produce big growth in the long run).  The fact that Tim Cook has activists like Carl Icahn breathing down his neck, with CNBC videotaping, obviously doesn’t help.

With that said, Wall Street culture isn’t the main reason that corporations aren’t engaging in new investment right now.  The main reason is that they don’t foresee a sufficiently attractive return, given the risk.  The current operating environment is weak–for all of the commonly cited reasons: high private sector debt levels (that need to be worked off), low consumer confidence (due to the trauma of the financial crisis), large wealth inequality, aging demographics, slowing population growth, secular stagnation, the lack of a “future” to build for, and so on.

Of the many factors that are holding back investment in the U.S. right now, only one of them can actually be controlled: demand.  The solution to the stagnation, then, is to aggressively increase demand with fiscal policy–deficit-financed government spending. Not a small dose that lasts a couple years, but a heavy dose that lasts a decade or longer. Ideally, the spending would come in the form of investment in infrastructure and research and development.  Such investment would increase the economy’s productive capacity, while putting spendable money directly into the pockets of average people.  It would spur the excess demand that is necessary to incentivize capacity-expansive corporate investment.  Not only would it incentivize such investment, it would force it–the only other option for corporations would be to let customer overflows go to competitors. At the same time, it would help to convert the excessive amount of private sector debt that exists in the U.S. economy–debt that is perpetually at risk of deleveraging in response to downturns and contagions–into safe, stable, rock-solid government debt, debt that can be easily “paid for” over time with low real interest rates. Government debt is the safest asset in the entire world of finance–our “bubble-bust” economy needs more of it, not less.

Now, back to Bill’s points.  He makes an interesting argument that connects writedowns to profit margins, deficits, and the financial crisis:

“Elevated profit margins are certainly pushing current EPS higher. These profit margins have been helped by large fiscal deficits that emerged in response to the crisis. And, of course, the crisis was the catalyst for the large write downs. It is inconsistent to discard what is having a negative impact on earnings without adjusting for those factors that are having a positive impact.”

I would take issue with the suggestion that presently elevated profit margins resulted from the deficits of the financial crisis.  They were high even before the crisis, when deficits were very low.  For corporations in the S&P 500, they were just as high they are now:   

profit margins

Valuation bears have been warning about elevated profit margins for more than a decade now.  With the exception of the recession-related pain of 2008 and 2009 (pain that was quickly reversed upon the recovery), the warnings haven’t panned out.

The following chart, borrowed from Deutsche Bank (my red emphasis), shows net profit margins for the S&P 500 back to 1967:


As we see in the chart, profit margins have been historically elevated for almost twenty years.  They are “cyclical” (they fall in recessions), but they are not “mean-reverting” (they were not “programmed” by God to permanently oscillate around some “natural” average). When valuation bears make their appeals to “profit margin mean-reversion”, they conflate the two concepts.

Outside of recessions, the observed elevation in S&P 500 profit margins has been quite persistent.  David Bianco of Deutsche Bank has done excellent work work to uncover some of the structural reasons why.


The argument for profit margin mean reversion is that if profit margins rise, corporations will eventually make investments to capture them from each other.  The ensuing competition will push prices down, just as the increased investment pushes labor costs up.  Therefore, profit margins will fall.  But one could make a similarly-styled argument for the mean-reversion of interest rates–that if interest rates are low, corporations will use the cheap funding to embark on an investment-spree that raises growth and inflation and pushes interest rates back up.  So, are interest rates “mean-reverting?”  Of course not.  Just ask Japan.  Or the U.S.

Simplistic arguments from “mean-reversion” have proven time and again that they don’t work in the real world.  They leave out important details.  There is no reason why the “natural” mean of an economic system–if such a thing exists–has to stay the same across decades, centuries, and millenia.  If a “natural” mean exists, it can change–that’s clearly what has happened in the case of U.S. growth rates (down), interest rates (down), profit margins (up), and the Shiller CAPE (up).  Eventually, the “natural” mean for these variables may change back in the other direction.  But let’s wait for the evidence that the change is happening before we build our investment strategies around it.

Outside of a dramatic policy error that causes a recession, there is no present mechanism for profit margins to fall to the levels that valuation bears are calling for.  And if a policy error does cause a recession, any fall in profit margins to those levels will quickly reverse in the recovery, as happened in 2002 and 2009.

Now, if the economy expands robustly from here forward, laborers will eventually gain more bargaining power (a good thing) and the Fed will eventually tighten monetary policy. Profit margins may therefore sustainably move lower. But it’s unlikely that they will move lower by the dramatic amount that valuation bears are calling for–a deep “reversion” to the arbitrary averages of prior eras, when the S&P 500 was dominated by “old economy” industries, when interest rates were sky high, and when labor unions ruled the day.

Right now, there is significant labor slack in the economy.  To get to a point where that slack tightens enough to pressure profit margins, substantial economic “catching up” needs to take place–years worth of expansion.  The top-line sales growth associated with such expansion will offset the EPS drag that the eventual margin decline will produce. On net, EPS will grow less than it otherwise would have grown.  But if the historical experience is any indication, it is not going to fall by much.  

The following chart shows recessions (black columns) and periods where S&P 500 EPS was more than 10% below its prior peak (red columns) from 1951 to 2013.   

s&p eps drop3

Notice that the red columns typically show up to the right of the black columns. The implication is that EPS tends to fall during and after recessions.  It doesn’t tend to fall during expansions.  Post-war history has only provided two counterexamples: 1985-1987 and 1951-1952.  In 1985-1987, the fall was small–less than 15%.  Interestingly, the market didn’t even pay attention–it proceeded to boom on rising investor optimism.  In 1951, EPS fell for legislative rather than macroeconomic reasons.  Congress instituted a large excess corporate profits tax to help finance the Korean war.

In 1966, profit margins were peaking.  Over the ensuing years, they fell as labor gained share.  But crucially, EPS did not fall alongside them.  Rising nominal sales growth allowed EPS to continue its advance (albeit at a slower rate).  EPS didn’t hit its eventual peak for the cycle until a few months before the 1970 recession.

Recessions have typically been caused by overtightening on the part of the Fed.  The classic signal of a recession is an inverted yield curve (blue line below zero):


Right now, the yield curve is extremely steep, a reflection of the fact that Fed policy is easier than it has ever been in U.S. history.  We simply are not in the kind of environment that produces recessions, and therefore we are not in the kind of environment that produces sizeable drops in EPS.

Bill concludes his defense by presenting a chart from John Hussman that correlates the Shiller CAPE to future 10 year returns (my emphasis in green):


The changes in accounting regulations occurred in 2001.  The change in the dividend payout ratio began in the mid 1990s.  Obviously, correlations in the chart that occurred prior to those periods cannot speak to those issues.  We don’t have a large sample size of 10 year returns after 2001 to test the metric, but for much of the small sample that we do have, the metric has been meaningfully underpredicting the actual outcomes.

As a case in point, consider late 2003, early 2004 in the chart (solid green line).  The 10 year total return prediction appears to be around 3%.  But the actual 10 year total return ended up being more than twice that amount–7%.  Valuation bears will explain the underprediction by arguing that the current market is severely overvalued, but this explanation begs the question.  Is the current market severely overvalued (at 17 times trailing operating earnings, a number roughly equal to the average of the last 10 years), or is the metric flawed in its construction and its aggressive assumptions about mean-reversion?

In January 2004, the Shiller CAPE was around 27, significantly above its historical average of around 17.  The S&P 500 profit margin (on trailing operating earnings) was around 8%, significantly above its historical average somewhere between 5% and 6%. Both of these “elevated” values were supposed to mean-revert.  Well, sorry, that didn’t happen–not even close.  Instead of blaming the error on mistakes that the market is making now, valuation bears should blame the error on mistakes that their metric made back then.  Its assumptions turned out to be wrong.

When we look at the chart in closer detail, we see that the metric has been frequently underpredicting subsequent 10 year returns since around 1994.  The predictive power gets markedly better in the late 1990s, but that’s only because a financial crisis occurred in the late 2000s that significantly depressed 10 year returns for the period.  If you were to remove the crisis–that is, if you were to hold stock prices constant from late 2007 until early 2013, when they completed the retrace of their earlier fall–the underprediction since 1994 would be visually evident in the chart.

Now, it’s a fair question: on what basis can we just hypothetically “remove” the financial crisis from the data set, pretend that it never happened?  It’s the outcome that reality produced, it needs to be included.  But there’s a deeper issue here.  Did the market somehow “know” that it needed to crash in order to make the metric’s predictions come true?  If not, then the metric got lucky.  Luck is not accuracy.

The claim being made is that the Shiller CAPE is naturally mean-reverting.  If it’s naturally mean-reverting, then an environment of fear and panic should not be required to keep it at its “natural” average.  It should be inclined to go to that average, and remain near that average, and sometimes even fall below that average, under normal operating conditions. Over the last 20 years, the Shiller CAPE has shown no such inclination.

We’ve either been in recession and crisis, in which case the metric has temporarily fallen to “normal” historical levels (actually not really: in the 2001-2003 recession and bear market, it didn’t even get close to those levels), or we’ve been in normal environments, in which case the metric has floated up to elevated levels–and stayed at those levels.  This is a clear sign that the metric as currently applied is flawed.  Normal operating conditions are not capable of producing allegedly “normal” values of it.

So what do we do?  If we’re being honest with ourselves, we either admit that the “normal” values of the metric have shifted upwards (due to the impact of structurally low inflation and interest rates, improved policymaker understanding and support of the economy, reduced tail risk, an increase in retail access to the stock market, a better-informed class of investors that more efficiently identifies and collapses excessive risk premia that would have been left in the system in the past, changes in tax rates on dividends and capital gains –take your pick), or we identify potential sources of distortion in the metric that can help explain its recent failures (changes to accounting standards, dividend payout ratios, etc.).  In the prior piece, I argued that both types of factors are involved.

The equation in Dr. Hussman’s chart models future returns on the assumption that the Shiller CAPE is going to mean revert from its current value around 25 to some value around 17 (Cavg in the equation), producing depressed total returns.  For perspective on how aggressive this assumption is, consider the following.  From January 1871 to January 1990, the GAAP Shiller CAPE spent 68% of the time below 17.  The average and median values of the metric were actually lower, around 15.  But from January 1990 to January 2014, the GAAP Shiller CAPE has spent less than 7% of the time below 17.  If we start from January 1995, the number is even lower–4% of the time.  Out of the last 228 months–19 calender years–the metric has only spent 10 months below its alleged “natural” average.  And the only thing that pushed it below that average, for those brief 10 months, was a massive, once-in-a-generation financial crisis.  As soon as the crisis eased, the metric floated right back up–to the evident frustration of Dr. Hussman and all of the other members of the school of “normalized valuation”: Andrew Smithers, Jeremy Grantham, and so on (a very smart group, mind you).  In light of these facts, can there be any question that something has changed, that 17 is no longer the Shiller CAPE’s “natural” average?

Now, in hearing this suggestion, readers will scoff: “So you’re saying this time is different?” Of course I am.  Of course this time is different.  By suppressing this conclusion, even when the data is screaming it in our faces, we hinder our ability to adapt and evolve as investors.  Reality doesn’t care if “this time is different” will upset people’s assumptions and models for how things are supposed to happen. It will do whatever it wants to do.

Instead of coming at the Shiller CAPE debate from the perspective of financial speculators entangled in a fight over each other’s money (which is what we ultimately are), let’s assume that we’re just lowly scientists studying a physical system (astronomical, meteorological, whatever).  We come to believe that the system has some “natural” average, which is the value that it’s always reverted to in the past.  But then suppose that over some long period of time–decades–the system drifts up to meaningfully higher values.  Importantly, in the absence of perturbation, it stays at those values. We get curious, so we take a closer look.  We find out that out of the last 228 monthly measurements that have been taken on the system, covering a period of 19 calender years, the values have only fallen below the “natural” average 4% of the time. That 4% directly coincided with a once-in-a-generation insult to the system.  As soon as the insult was removed, the values quickly climbed back up–and stayed up, and are still up, showing every sign of staying up, unless and until they meet another insult.  Would we hesitate, even for a moment, to acknowledge the obvious: that the “natural” average of the system is not what we thought it was, what it used to be?  Would we hesitate to acknowledge that “this time is different?”  Of course not.

Closing Thoughts

Let me be clear.  I’m not saying that the U.S. stock market is cheap.  It’s not cheap.  It’s expensive–but only relative to the past, relative to the returns that our mothers and our fathers and our grandmothers and our grandfathers earned.  Relative to the present–the present menu of investment options–it’s appropriately valued.  That’s what matters.

In a subsequent piece, I will offer a rigorous estimate of future 10 year returns, based on a conservative set of assumptions about S&P 500 revenues and profit margins.  On these assumptions, the stock market at 1775 (the level at which the discussion began–the extra 60 points since then belong to me) will produce a nominal 10 year total return somewhere between 5% and 6% per year.  That’s not a great return, but it’s  not an unreasonable return, especially in light of the meager returns that cash and bonds are offering and will likely continue to offer.

The biggest mistake that valuation bears have made in this cycle is to assume that if the average stock market return over history is 10%, that you should therefore expect that return even under low interest rate conditions, that the market will eventually offer it to you, once its “overvaluation” is worked off.  No.  In the absence of an insult or perturbation that produces highly abnormal levels of risk aversion–a depression, a world war, a deep recession, a banking crisis–the market is not capable of offering stockholders 10% returns while it offers bondholders and cashholders 3% and less than 1% respectively.  With an equity premium that high, everyone would choose to hold stocks–including the valuation bears.  But someone always has to hold the other stuff, therefore the return on stocks would be bid down as the price is bid up.

It follows that if you’re patiently waiting for 10% equity returns to be offered to you right now, you’re either waiting for some kind of crisis that puts investors in an irrational state of mind (the state of mind they’ve been working off since Lehman), or you’re waiting for a significant Fed tightening–not to 2005-type levels, but to pre-1995-type levels.  In my opinion, you’re waiting for Godot.

With that said, the current market is heavily overextended, with increasingly lopsided sentiment.  In terms of monetary policy, we’re at a potential turning point, where improving growth may force the Fed to shift from “ridiculously easy” to just “easy”, and where many market participants will wrongly extrapolate to the next step: “tight.”  As the market digests the changes, it would hardly be surprising to see a 5% to 10% correction occur.  In my estimation, the current market would be very willing to finally throw the bears a lifeline, and embark on such a correction, in the presence of an appropriate catalyst (which it can’t currently seem to find). If a 10% correction were to occur, the 10 year equity return would rise by around 100 bps.  The extra return might be worth waiting for.

But if we get a correction, and if the inflation picture remains such that the Fed is able to maintain an accommodative stance, then buy it.  Don’t start talking about “this is it”, “the top is in”, “50% crash over the next decade”, “record profit margins”, “mean reversion”, “elevated Shiller CAPE”, “S&P 500 fair value of 1000”, “stocks are overvalued on normalized earnings”, and so on.  That type of thinking doesn’t work.  It doesn’t make money–just look at the last five years, or the last ten years.  Nobody who has actually put it into practice has made anything.

What makes money in markets is buying temporary weakness in a rising trend, preferably in an attractively valued asset, and selling temporary strength in a falling trend, preferably in an unattractively valued asset.  The trend for stocks is set by the business cycle and monetary policy.  Valuations are determined by the earnings that actually get produced in reality–not by the earnings that “should have been” produced based on tenuous assumptions about mean-reversion.

Right now, the U.S. stock market is unquestionably in a rising long-term trend, with valuations that are still defensible.  On pretty much every metric available, stocks are roughly at the same valuation that they were ten years ago, if not cheaper.  Ten years ago, in January of 2004, the bull market was only 10 months old.  It had more than 3 years and 45% to go.  As is the case now, that time was a time to be looking for dips to buy, opportunities to increase exposure, not a time to be worrying about the Shiller CAPE.

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