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Prof. Schiller and CAPE Maybe Correct Generally But Specifically Wrong – The Market Is Currently Cheap (PEP, ORCL, WMT, JNJ, PG, MDT)

Many well-known stock market pundits, including the likes of Henry Blodgett, point to Professor Robert Shiller's cyclically adjusted P/E ratio or CAPE to make a case that the stock market (S&P 500) is overvalued. According to Prof. Shiller, the long-term average P/E ratio (CAPE adjusted) for the S&P 500 is approximately 16. And today, according to CAPE (cyclically adjusted P/E) the S&P 500 sits at a CAPE P/E ratio of approximately 24 or so. Therefore, according to the statistical analysis, the S&P 500 is 20% to 30% overvalued.

The thesis of this article is that although Prof. Shiller may eventually end up being correct, and we emphasize "may", his hypothesis is vague and imprecise, and therefore, too general to be of value. On the other hand, we emphatically hold that he is categorically wrong regarding specific blue-chip U.S. corporations. Furthermore, we also contend that on an absolute basis (precise calculation of earnings) the S&P 500 is undervalued based on historical norms.

Therefore, we are concerned that these statistically inferred measurements of so-called overvaluation could deter investors from investing in or owning our best companies at precisely the time when their valuations are low and the long-term rewards are better than they have been in decades. Furthermore, thanks to these low valuations, the risk of owning blue-chip stocks is simultaneously lower than it has been in a long time.

What CAPE Really Says

Prof. Shiller's cyclically adjusted P/E ratio (CAPE) calculates an average of 10 years of S&P 500 earnings, which is used as the level of earnings with which to divide into the current price of the S&P 500 in order to determine the CAPE P/E ratio. This calculation, which theoretically takes into consideration the cyclicality of the S&P 500's earnings, is promoted as being superior to forecasting future earnings. However, we will soon demonstrate that this is precisely what the CAPE measurement is doing — predicting or forecasting future earnings.

Furthermore, the only way that it can be of true value is if its implied forecast is correct in future time. Of course, it should also be recognized that this is no different than any other forecast methodology. The veracity of the assumptions underlying the hypothesis can only be proven if they produce an accurate future level of earnings, in this case for the S&P 500. Also, to be of any real value to investors, CAPE needs to offer a precise point in time when earnings are allegedly going to fall.

Mathematically, the actual forecast behind CAPE in the vast majority of cases is forecasting a lower level of future earnings on the S&P 500. This is because the S&P 500 earnings are generally increasing and only interrupted by the occasional recession. Therefore, CAPE is suggesting that the S&P 500 is overvalued based on a vague notion about future earnings, not current earnings.

Another claim that CAPE makes as being a superior methodology is that it uses as-reported earnings in contrast to operating earnings like most other prognosticators use. According to Standard & Poor's website, the following definitions to these earnings measurements are as follows:

"Operating earnings: income from product (goods and services), excludes corporate (M&A, financing, layoffs) and unusual items."

"As reported earnings: income from continuing operations, also known GAAP (Generally Accepted Accounting Principles) and As Reported

We do not intend to debate which of these earnings measurements represent better reflections of a company's profitability. However, we will emphatically state that after decades of producing earnings and price correlated F.A.S.T. Graphs™ on individual companies, that the market places a higher correlation on price and earnings with operating earnings than it does with as reported earnings. Therefore, our research tool calculates growth rates and earnings justified valuation lines based on operating earnings.

With the above in mind, and in the spirit of fairness, we have calculated the S&P 500 CAPE valuation based on the 10-year time period Dec. 31, 2001 to Dec. 31, 2010, using both operating earnings and as-reported earnings. We chose this time frame because it is the most recent completed 10-year period, so all numbers are actual. Therefore, no estimates are used. We pulled both earnings numbers directly from the Standard & Poor's 500 index data. Our calculations are as follows:

On an as-reported basis, the 10-year average S&P 500 earnings would be $52.03, and by dividing that number into the S&P 500 price on Dec. 31, 2010 of $1257.64, we came up with a CAPE of 24.17. On an operating basis, the 10-year average S&P 500 earnings would be $64.41, and by dividing it into the same S&P 500 price we came up with a modified operating earnings CAPE of 19.5. Both of these CAPE calculations are above the historical normal 16 P/E ratio according to Prof. Shiller.

There are several important points to consider here. First, this time frame includes the two recessions of 2001 and 2002. Second, future S&P 500 earnings must fall to CAPE calculated $52.03 (an implicit forecast) in order to validate the overvaluation thesis behind them. That would require an earnings drop in excess of 54%, which is more than even the great recession of 2008. Next, this calculation would only be relevant to an index investor. Finally, this refers to an index that contains numerous cyclical stocks; however, as we will later illustrate, not all S&P 500 stocks are cyclical in nature.

The P/E Ratio Based on Actual Earnings

The following earnings and price correlated graph on the S&P 500 was selected to illustrate valuation based on actual earnings. There are two P/E ratio lines that are drawn on the graph. The blue line (normal P/E ratio) represents the widely accepted normal P/E ratio of 20 that applies to approximately the last 50 years. The orange earnings justified valuation P/E line represents the longer term historical P/E ratio of 15, which is generally accepted as fair value for the average company and approximates the P/E of 16 that Prof. Shiller embraces. The starting year 1995 was chosen because it was the most recent year (excluding the recession of 2008) where the S&P 500 was actually fairly valued with a P/E of 15. The graph ends in 2010 because it is the last completed calendar year.

We believe that this graph provides a much more relevant depiction of valuation based on a clearer correlation between earnings and price. By reviewing this graph, it becomes crystal clear that the S&P 500 has, as Prof. Shiller currently contends, been mostly overvalued since 1995. The 20 P/E ratio blue line is a trimmed average P/E ratio where the highest and lowest P/Es have been discarded. We believe this presents a clear picture of a major fallacy behind relying on statistical analysis.

Although the 50-year P/E of 20 calculates and validates the statistical calculation, from the graph, it is clear that the market has only occasionally traded at the 20 PE. Over much of the time, the S&P 500 traded both above and below the statistical reference point. Perhaps this validates the old adage that statistics don't lie, but statisticians are darn liars.

However, we believe the real value that the following graphic provides the perspective investor is the lesson on the importance of valuation and earnings growth to shareholder returns. This graphic shows that the S&P 500 was fairly valued with a P/E ratio of 15 (price touched the orange earnings justified valuation line) at the beginning of 1995. However, equally as importantly, the price also ended in calendar year 2010 at precisely the same fair value P/E of 15. Although there was a lot of overvaluation, and a couple of recessions in between, the earnings growth rate of the S&P 500 averaged 6.1%.

SP%20Chart%201.png

The 16-year performance results associated with the above earnings- and price-correlated graph of the S&P 500 establishes the importance of valuation and earnings growth. The closing annualized rate of return of 6.4% correlates almost perfectly with the 6.1% earnings growth rate. The additional $66,000 worth of dividends paid (assumed spent, not reinvested), kicks the total annualized return up to a respectable 7.9% (see red circle) per annum. Attractive and fair valuation at both the beginning and the end of this time period validates sound investing practices.

SP%20Chart%202%20perf.png

The next graph covers the period 1992 to Oct. 20, 2011. The focal point should be the current absolute low valuation of the S&P 500 relative to the last 20 years. The indicated fair value based on a 15 P/E times the estimated operating earnings of $97.88 indicates fair year-end 2011 value of approximately 1470 (see flag on graph), which is approximately 23% higher than current. In other words, on an absolute basis we believe the S&P 500 currently is 23% undervalued, not 30% overvalued.

SP%20Chart%203.png

The following estimated earnings and return calculator is based on Standard & Poor's own current estimate for calendar year 2011, followed by Bloomberg's estimates for fiscal year 2012 and 2013. In a report published on Oct. 7, 2011 on Bloomberg.com, Wendy Soong reported Bloomberg's earnings estimates for the S&P 500 in total and for each sector. Bloomberg forecasts an 11.7% share-weighted earnings growth in 2012 followed by 10.9% in 2013.

SP%20Chart%204%20forecasting.png

The following hypothetical estimated earnings and return calculator uses a $50 earnings estimate (approximate CAPE calculation) for the S&P 500 in calendar year 2010 based on the only practical outcome that would validate Prof. Shiller's CAPE calculations. This would imply that the S&P 500 earnings would have to fall by more than 54% from Bloomberg's 2013 estimate. Remember that CAPE does not provide a precise date, so calendar year 2014 was arbitrarily plugged in. That would be a significantly greater collapse than the recession of calendar year 2001's 30% drop, or than calendar year 2008's 40% drop.

SP%20Chart%205%20forecasting.png

The real point being made is that Prof. Shiller is forecasting future earnings with his calculations either intentionally or by proxy, just like everyone else. The major difference is that Prof. Shiller is simply using statistical references based on historical data going back to the 1800s. Although many would disagree, we argue that recent economic history is much more relevant and representative than what the economy was like in the 1800s or early 1900s. The productivity enhancements from technology alone render the economies of 100 or more years ago incomparable to today's.

It can't be ruled out that earnings could drop by the magnitude that Prof. Shiller's calculations indicate. However, as previously mentioned, we would like to see a specific date when this would occur. We do believe that it's highly unlikely and therefore, we are much more comfortable with Bloomberg's numbers. Of course, we acknowledge that many doom and gloomers do believe this is a likely future occurrence.

A careful review of the 20-year historical earnings and price correlated graphs do show that the S&P 500 is cyclical, so anything is certainly possible. However, it is important to keep the threat of recession in perspective; they are often short-lived and eventually followed by higher earnings and ultimately higher stock prices. Consequently, we believe a major problem with CAPE is its continuous implied forecast of falling earnings. This can cause investors to miss years of future returns based on a fear of some unknown and only hypothetical event.

Why He Is Specifically Wrong

Therefore, the biggest problem that we have with mere statistical inferences like CAPE, are concerned with the potential danger they present to the investing public. Inundated with dire warnings of another decade of very poor returns based on these mindless number crunching exercises, many investors are fleeing equities in favor of other, perhaps even uncharacteristically more risky investments like long-term bonds when interest rates are at their lowest levels in decades.

What's unfortunate about this scenario is that after decades where stocks, at least as represented by the S&P 500, were truly overvalued, they have finally become attractive. Therefore, at precisely a time when equities represent the best opportunity and the lowest risk profile that they have in decades, investors are afraid to own them thanks to academic exercises like CAPE.

A significant portion of our argument is based on the undeniable reality that not all stocks in the S&P 500 are cyclical. And CAPE, as we believe we have clearly established, can only be relevant if cyclicality is present. In other words, CAPE only makes sense if future earnings will be significantly lower than current earnings. If you average a steadily increasing series of numbers, the average will be lower than the last number in the series. Yet in truth, the last number, and typically the highest in the series is the current and more relevant number.

What follows are two specific examples of blue-chip dividend growth stocks that have proven to be very recession-resistant, or noncyclical, and are clearly trading at historically low valuations due to nothing other than unsubstantiated negative sentiment. There are many other examples such as Procter & Gamble (PG), Johnson & Johnson (JNJ), Abbott Labs (ABT), Medtronic (MDT) and many others too numerous to mention that could also be reviewed.

Our first example is PepsiCo Inc. (PEP). From the earnings and price correlated F.A.S.T. Graphs™ below it is clear that PepsiCo's earnings have steadily increased (the orange line) right through both the recessions of 2001 and 2008 (recessions shaded red). Furthermore, it is also clear from the graph below that PepsiCo's stock is trading at, and in fact, slightly below fair value for the first time since calendar year 1995. This implies the opportunity to invest in this company at the lowest risk, with the highest yield and therefore perhaps best long-term opportunity in a long, long time. We do not believe that investors should be afraid of investing in a blue-chip like PepsiCo at such a historically low valuation.

PEP%20Chart%206.png

Our second example looks at Walmart Stores Inc. WMT), a potentially faster-growing, recession-resistant company, over the same 1995 to Oct. 10, 2011 time frame. After becoming excessively overvalued over the period 1995 to year-end 1999, Walmart's share price went sideways before finally reverting back to fair value by the end of September 2007. Consequently, what had been a dangerously overvalued blue-chip company for many years, has finally and recently become an attractive investment opportunity. Today's current undervaluation with a blended P/E ratio below 13 represents an extraordinary opportunity to invest in this king of retailers, in our opinion. Followers of CAPE would be denied this tremendous opportunity.

WMT%20Chart%208.png

Our third example reviews Oracle Corp. (ORCL), a leading technology and above-average growth stock that also has an impeccable recession-resistant operating history. But most importantly, in spite of their excellent record of earnings growth, Oracle's shares are currently available at one of the lowest valuations in decades. For the total-return investor interested in growing their capital, it would be a travesty to be thwarted from investing in this great technology company by CAPE.

ORCL%20Chart%209.png

Even when Oracle Corp.'s performance is calculated under the backdrop of one of its lowest valuations in years, the following associated performance results illustrate its investment merit. This is clearly, and factually, a significantly above-average business.

ORCL%20Chart%2010.png

Conclusions

This is the first of what will be a series of articles arguing in favor of investing in and owning quality common stocks now and for the foreseeable future. On an absolute basis, on real numbers precisely calculated, we believe that the markets in general are attractively valued today. The CAPE measurement used by Prof. Shiller is a hypothetical statistic with no precise time designation, only an assumption. The F.A.S.T. Graphs™ S&P 500 graph calculation is a current fact.

Therefore, we believe that some of our finest and highest quality businesses are currently priced at the best valuations that we've seen in many years. Low valuations, like we see today, represent an excellent opportunity for investors. As Warren Buffett has wisely advised: "Be fearful when others are greedy and greedy when others are fearful." With so many people afraid today, there's a cornucopia of quality common stocks available. This article highlighted but a few.

We will follow this article with a series of three articles dissecting the Dow Jones Industrial Average through the lens of our earnings and price correlated F.A.S.T. Graphs™ research tool. Our objective is to clearly illustrate that it is always a market of stocks, rather than a stock market. One of our greatest objections to statistical inferences such as CAPE, and even Modern Portfolio Theory (MPT), is their emphasis on generalities while simultaneously ignoring the more relevant specifics.

Recently there have been many who are arguing against the ability or even desirability of stock selection as a viable strategy. We believe they are wrong, that success leaves clues, and that discerning investors can make wise and sound decisions with the proper tools and disciplines.

Disclosure: Long PEP, ORCL, JNJ, PG, MDT, ABT at the time of writing. Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment adviser as to the suitability of such investments for his specific situation.

About the author:

Chuck Carnevale
Charles (Chuck) C. Carnevale is the creator of F.A.S.T. Graphs™. Chuck is also co-founder of an investment management firm. He has been working in the securities industry since 1970: he has been a partner with a private NYSE member firm, the President of a NASD firm, Vice President and Regional Marketing Director for a major AMEX listed company, and an Associate Vice President and Investment Consulting Services Coordinator for a major NYSE member firm.

Prior to forming his own investment firm, he was a partner in a 30-year-old established registered investment advisory in Tampa, Florida. Chuck holds a Bachelor of Science in Economics and Finance from the University of Tampa. Chuck is a sought-after public speaker who is very passionate about spreading the critical message of prudence in money management. Chuck is a Veteran of the Vietnam War and was awarded both the Bronze Star and the Vietnam Honor Medal.

Visit Chuck Carnevale's Website


Rating: 3.3/5 (27 votes)

Comments

Ungoat
Ungoat - 3 years ago
I agree with you that stocks are a decent investment now (at least in relative terms). I even own some of the names you mention: WMT, JNJ, KO instead of PEP, and so on.

But it seems to me that you've used a very complicated argument to try to discredit CAPE, which is a very simple idea.

You'd rather value the market based on a year of earnings than on a single quarter. Shiller is just suggesting that its better to value the market based on 10 years of earnings than based on 1 year.

The fact that earnings 10 years ago are typically lower than current earnings doesn't discredit this. There should still be a clear statistical relationship between 10 year average earnings, current prices, and future market returns. And the data tend to support this.

chuckc
Chuckc - 3 years ago


Ungoat,

Thanks for your perspective. But I still want to see a precise estimate at a specific date, not just a vague never ending negative outlook. Ultimately, a PE is a multiple of earnings, and current earnings are available, while future earnings are yet known. But most importantly, I lokk at stocks (businesses) one at a time, rather than as a index. But I do respect your opinion.

Regards,

Chuck

mla
Mla - 3 years ago
Right, but you're doing exactly the same thing: you're saying you estimate the market is undervalued by 23% (or whatever). So when is the date that the market price will reflect that estimate? You have no idea, and neither do I. I don't see why it's methodologically sound to forecast an optimistic result verses a pessimistic result. This is where "margin for error" comes in, right? Buy low enough that you can be substantially wrong and still not lose significant money.

In terms of cyclicality, I've heard (but can offer no proof) that margins tend to be mean reverting. Hussman talks about that quite a bit (http://www.hussmanfunds.com). Not to suggest there aren't exceptions or per-company variance, but with transfer payments being used to prop up demand (something like 7% of GDP), you have to wonder what happens if that safety net fails.

There are other methods somewhat similar to CAPE. See the Q-ratio, for example. They often track each other reasonably well. Hussman also uses a "peak earnings" metric that you might find interesting. I haven't looked deeply at your FAST method but will do so.

I think the basis of CAPE goes back at least to Ben Graham and probably longer. He recommended looking at many years of past earnings rather than just current. I don't have the reference handy but this blog entry discusses it:

http://www.thesimpledollar.com/category/the-intelligent-investor/page/2/
Rommel Acosta
Rommel Acosta - 3 years ago
Well said Mla.

Carnevale, I don't disagree that specific stocks are cheap. There are always cheap stocks and expensive stocks no matter the level of the market. The stocks you mentioned, some of them I own.

I think the point of the CAPE (which Ben Graham thought was a good tool) is to give you a sense of the general market valuations, which, if high, means the odds are against you. Doesn't mean you won't make money. It's just there to provide context to the specific investing decision.

If you think of what a P/E is, it's a shortcut DCF, so it really is superior to use multiple years instead of just one. It also gives you a better idea of earnings over a business cycle.
jrhubbard
Jrhubbard - 3 years ago
Agreed with Mla. Here is a specific commentary by John Hussman on the use of the peak-earnings valuation methodology (which is comparable with Shiller's CAPE methodology):

http://www.hussmanfunds.com/wmc/wmc101101.htm

The graph about a page down demonstrates the historical accuracy of the model. Also, to color your point about a certain CAPE ratio implying a certain degree of falling earnings, you are falling into your own intellectual trap where you assume that the reversion is going to take place overnight. Neither Shiller nor Hussman come to this conclusion with their own methodologies. Rather, they recognize that high valuations mean that long-term returns are stretched low and risk (drawdown) is stretched high. It might mean 10-year returns of 4% instead of 10%. See Hussman's notes on Shiller's methodology in the table on this commentary:

http://www.hussmanfunds.com/wmc/wmc110314.htm

The one thing I would agree with wholeheartedly is that high valuations call for much higher selectivity in individual stock selection. Absolutely critical.
Topwine
Topwine - 3 years ago
Dear Chuc

I agree with all the above arguments against your conclusion and your reasoning.

I think you FUNDAMENTALLY misunderstands the calculation of Prof. Shillers CAPE ratio and it's use.

I also do agree though that there is individual stocks that are cheap. Profit margins are at historical highs though, and this could change the picture. The whole idea of an historical index like CAPE, is not to predict anything. Where did you get that idea? It is to show what has historically happened and for you to decide how to use that in your own decisions.

chuckc
Chuckc - 3 years ago


Mia,

Thank you so much for your input and the opportunity to

clarify my position. I think we agree more than we disagree. I am a major

proponent of Ben Graham and his teachings. He had a major influence on my

desire to develop my F.A.S.T. graphs (Fundamentals

Analyzer Software Tool) which

provide the ability to review many years of earnings at a glance and simultaneously

see how price relates to those earnings. The following quote from the blog you

cited is precisely what F.A.S.T. graphs are designed to do:

“What should you do instead? You should look at earnings over as

many years as you possibly can and attempt to get a real bead on the direction

the company is going over the long term. A single year is not enough to

accurately judge the direction of the company.”


This is far different than simply

averaging 10 years of numbers and using it as a proxy for the necessary in

depth analysis required to evaluate a business (stock). The blog post you cited

also discusses the importance of doing the work as follows:

“What can you do here? If

you use that short-term number for anything important, you need to do some

serious research into the stock. Read the annual report. Read the SEC filings.

Dig into the details of what is actually included in the earnings number being

used here. What’s being included in it? Are there “one time charges” all over

the place? What are those charges, and how would the number change without

those charges?”


Yes, I

agree that I am attempting to forecast a future number, but I disagree that I

am attempting to do the same thing as CAPE. My F.A.S.T. graphs tool is

the first step in a comprehensive research effort. However, it does provide

essential fundamentals at a glance, so like Ben Graham recommended, I can look

at many years of earnings (from the last 2 up to 20, I used 17 years in the

article) “to get a real bead on the direction the company is going over the

long term.”

This

is far different than running a simple 10 year average of a series of numbers

and relying on that same number to base my decisions on. The blog post you

cited also covers this as follows:

“What’s

the real lesson that Graham is teaching?
There is no single number

that you can use to really evaluate a stock or a company.
There are so many tricks

that a company can use to manipulate their numbers, both legitimately and

otherwise, that relying on a single number to judge a company is a fool’s game.

You’re begging for a company to trick you if you rely on minimal information.”


A major point of my article was to encourage investors to do

real work when evaluating a potential stock investment. Relying on a mere

statistical inference can be very misleading IMHO. A series of 10 years of

earning can be very different and erratic, a simple average reveals none of

that, and I feel it is important. I am

currently preparing a series of three articles where I will dissect the Dow 30.

In parts two and three you will see examples of very erratic (cyclical) earnings

records, and how price responds. I hope you read them as well. F.A.S.T. graphs were

designed to make the research process as efficient as possible, but alas not

easy, just easier. We might all desire easy answers, but in my experience they

don’t exist.

No one, as you stated, can precisely forecast the future.

However, our results depend on our getting as close as possible. The only way

to do that is to truly follow the teachings of investing giants like Ben Graham

and do the heavy lifting required to come to as learned a decision as possible.

Thanks again for comment, I appreciate your reading my work whether

you agree or disagree. The sharing of dialogue and ideas is how we all grow.

Regards,

Chuck

chuckc
Chuckc - 3 years ago


Rommel Acosta, Jrhubbard, Topwine et all,

I respectfully disagree that

I do not understand Schiller or Hussman, because I believe that I do. My real

problem, as I stated in the article, is how relying on a simple statistical

reference can deter people from investing in what might be (I believe it is)

the best opportunity to invest in common stocks in decades. Especially in the

best of breed companies that are currently trading at low valuations on an

absolute basis. Furthermore, the ones I like best rarely experience the major

drop in earnings that CAPE implies will occur.

My point is that real

research is necessary to get the job done (see my response to MIA). I thank you

all for responding and appreciate your reading my work. I have no interest in denigrating

Schiller’s or anyone else’s work, but if I disagree I will state my case as

factually as I possibly can. My objective is always to stimulate thinking and

dialogue always contributes. I hope you read my next three articles which

expand on my view that many specific stocks are attractively valued today for

the first time since 1995.

Thanks again for your

contributions ,

Chuck

jameshou
Jameshou premium member - 3 years ago


Chuck, thanks for your very detailed analysis. I have a question.

Currently the operating margin for S&P500 is around 9%, which compares to historical average of 5%. This has been pointed out by a number of well know investors and academics. Some have argued that margin will revert to historical means as a result of

1. higher tax rate. In 1970s the US corporate tax rate was around 50%, vs. approx 30% currently

2. government spending cuts. The government spending over the past 20 years has risen significantly. I can find the precise statistics for you

3. a lot of the corporations have become more international and as a result can expand their earnings and reduce costs through cheap labour

4. companies have been able to increase earning through cost cutting. However a lot of these corporations have cut their expenses to the bone. Is this sustainable?

The market is expecting around $90 - $100 of earnings for S&P in 2012, making the market look cheap, especially when compared to bond yield. However if the margin for S&P revert to historical mean, its earnings may drop significantly, say to $60.

Given this risk, do you still believe the market is attractively valued today?
tkervin
Tkervin - 3 years ago
Lots of ways to skin this cat. I tend to follow Buffett's metric of the ratio between total US equity market cap and GDP. That approach puts us firmly in the "fair value" range for market valuation. That falls nicely between Mr. Shiller's and Mr. Carnevale's methods.

Now the question is of what value are any of these metrics to the individual investor?

In this regard I will only speak to my approach. Ben Graham suggested a mix between bonds and equities based on market valuation. I use Buffett's ratio to guide my asset allocation mix.

My current 65/35 split between equities and "other", (bonds, cash, non equity holdings) is based on my personal circumstances, income streams, age, and family situation. Your mileage may vary!

As a sixty year old business owner my situation is quite different than it was when I began investing as a much younger man.

How you chose your equities is a topic that merits its' own thread. In brief I tend to stick to companies that have a track record of generating returns in excess of their cost of capital and also have shown the ability not to squander this cash flow. My starting point is Morningstar's "Fair Value" estimation for "Wide Moat" companies with strong balance sheets and good management. I always assume that MorningStar is optimistic and never "Pull the Trigger" on a buy order unless the equity is, at the minimum, 25% under a fair value calculation. I am not finding many that pass my hurdles currently, though I have made a number of buys in the last ninety days. Interestingly, most of my picks agree with the F.A.S.T. Graphs analysis of Mr. Carnevale. (We will agree to disagree on RIMM.....:-)

I appreciate the topic. All of Mr. Carnevale's articles are very well reasoned.
jameshou
Jameshou premium member - 3 years ago


Thanks Chuck for your detailed response. I agree with your reasoning. It is sometimes hard to see the forest beyond the trees when confronted with so many uncertainties. what I am deeply concerned with is another Lehman type GFC crisis, in which we saw portfolios of even great investors tank between 20 - 50%. That is why I have been so focused on the level of the market.
Rommel Acosta
Rommel Acosta - 3 years ago
Chuck, thanks for your thoughts. Certainly did not mean to imply that you didn't understand the ratio, my personal opinion is just that you pay more attention to it during a period like this one, given all the risks. You would probably require a higher margin of safety than normally.
ilovesummer
Ilovesummer premium member - 3 years ago
This is a better analysis than CAPE .

Investor sentiment and consumer sentiment are also great market indicators.

Shiller is in the negative crowd so his opinion is added to the other negatives.

It really doesn't matter the names of the negatives , just the amount of them.

The whole buying while blood in the streets not champagne comes to mind.

The market is getting pushed down by unemployment , debt , housing , Europe ,

China bubble , dollar and still the market is holding on quite well. Normally one of these

things would sink the market.

Should the picture brighten the market could turn up very strongly.
jrhubbard
Jrhubbard - 3 years ago
This has been an interesting discussion. Implied in Shiller's and Hussman's valuation methodologies are the assumption the profits are mean-reverting (they are currently at generational highs). I say implied because there is no mechanism in the model to adjust, but the assumption is that over ten years they will average out. As Jeremy Grantham has said, "If profits aren't mean-reverting, then capitalism is broken." However, lately, profits have not been mean-reverting. They have been expanding.
mla
Mla - 3 years ago
@jrhubbard: agreed, margins have been continuing to expand. I heard a fascinating theory about that: that part of the reason is the increased debt-financed government spending.

I haven't really thought about it, but it does make some sense. Government spending as a percentage of GDP went from something like 19% to 25%. To the degree there's artificial demand generated by government transfer payments, there can be earnings with no corresponding wages (at the macro level). IOW, toward the limit, wages become an externality. That's unsustainable long term, of course.
jrhubbard
Jrhubbard - 3 years ago
That's a fascinating theory. I agree with your conclusion that it is plausible in the short run. In the long run, it should create the same incentives for increased competition in the marketplace.

Hussman also ran a piece a while back where he showed that the profit margins most extended relative to history are in the basic materials and energy sectors. Aside from all the speculation regarding why this has occurred ("peak everything!", financialization of basic materials, debt-fueled above-trend growth in emerging markets), it is an interesting point to ponder because if you were to ignore those sectors, you might come to the conclusion that the rest of the market is a better value. How much better? I don't know. By his measures (and at the date of that specific commentary), the most undervalued sector by a large margin was Healthcare, which no one wants to touch. Of course, the former fact logically follows from the latter.

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