Why do stock prices vary so much?
In chapter four of “Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market,” author Mebane Faber reported that the multiples investors are willing to pay have varied widely over the history of the stock market.
They ranged from 5 to 45 (as in CAPEs of 5 and 45) and that means investors have paid as little as 5 times earnings to as much as 45 times earnings. One important reason for this variation is inflation. Faber wrote, “When inflation is in the 1-4% 'comfort zone,' investors are willing to pay a valuation premium compared to when there is high inflation or outright deflation.”
Next, he turned his attention to the best and worst times in stock market history to invest. To establish them, he studied all year-end periods with an assumed holding period for the next 10 years:
- During the 10 worst starting years, the starting CAPE (cyclically adjusted price-earnings) ratio was 23.31 and the 10-year return was -3.3%.
- Through the 10 best starting years, the starting CAPE ratio was 10.92 and the 10-year return was 16.10%.
Clearly, the lower the CAPE when initiating an investment, relatively speaking, the better. Faber pointed out that a couple of such starting points jump out in hindsight, including the early stage of the Roaring 20s, the late 1940s and the late 1980s.
On the flip side, the worst years often occurred at the end of “massive bull runs”; more broadly speaking, bull markets are the foundation for future bear markets, just as bear markets create a base for future bear markets. Put another way, the author said that the best starting points are relatively cheap, and the worst starting points are more costly.
The CAPE ratio and its critics
So far, we’ve seen a positive presentation about the CAPE ratio, how it can help us avoid bubbles, its ability to signal overvaluations and its edge over the traditional price-earnings ratio.
In chapter five, Faber told us investors also need to be aware of the drawbacks of the CAPE ratio. He argued that far too many of us stick to our models and opinions with “religious-like zeal.” He grouped criticisms of the CAPE into three categories.
First, many critics believe the CAPE measurement period is too long, and that booms and busts have an “outsized” impact on the ratio for too long. Faber cited research by Adam Butler and Mike Philbrick that looked at different measurement periods, from one to 30 years. They found that most of the measurement periods worked well, and had what they called “parameter stability.” Faber added that research discussed later in his book would conclude that the ideal duration is about seven years.
The second complaint about the CAPE ratio is that changes in accounting make it impossible to compare the ratio across decades. Beyond accounting rules, they point to write-downs and adjustments to the consumer price index.
What should we think of this criticism? According to Faber, there is some merit in this argument. He pointed to changes in the generally accepted accounting principles (GAAP) in the early 2000s that changed how goodwill was amortized. That, he wrote, could potentially bias earnings down and the CAPE ratio up.
Jeremy Siegel, the author of “Stocks for the Long Run,” and, according to Faber, Robert Shiller’s best friend, also voiced reservations. Siegel wrote that CAPE’s predictions are based on biased earnings data. That’s because changes to accounting standards in the 1990s made companies charge big write-offs when the assets they held dipped in price, but did not push up earnings unless the asset was sold.
According to Faber, he tried to recreate one of Siegel’s pieces of research, after Siegel claimed that the CAPE ratio was biased because of write-downs and an effect called “the aggregation bias.” Faber found that a ratio curve created with Siegel’s concerns looked much like Shiller’s; in absolute values, the Siegel curve was lower than the Shiller curve, but both were telling essentially the same story.
The third criticism of the CAPE ratio is that strong recessions bias the CAPE ratio too high, while bubbles bias the ratio too low. Faber followed up on this by testing the complaint that including the earnings of 2008-09 biased the CAPE ratio. He checked by adjusting earnings, so they did not go down in 2008 and 2009. On this basis, he found that the CAPE ratio moved down from 25 to 23, which really isn’t much difference at all. Stocks were still expensive and short-term oscillations had no material effect.
On a related note, Faber referenced the work of Wes Gray, who looked at individual stocks within the U.S. stock market. He found that the CAPE ratio worked well for selecting individual stocks as well as indexes.
Faber concluded chapter five by noting that the CAPE doesn’t work very well as a short-term indicator for one market. Calling it a “blunt” tool, he said it will be useless in picking a stock for the next few months but has potential for the long term. In this case, the look-ahead period should be 10 years, which aligns with the tool itself.
Conclusion
This was a review of chapters four and five of Faber’s book, “Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market.”
In chapter four, he examined the wide variations in the multiples of earnings that investors are prepared to pay for the same stock or index. He found that inflation was an important factor, and that investors were willing to pay a premium when inflation was relatively tame, between 1% and 4%. In addition, he determined that the best time to invest is when the CAPE ratio is relatively low, and that worst time to invest is when the CAPE is relatively high.
In chapter five, Faber looked at three criticisms of the CAPE ratio and determined that while some concerns were legitimate, there is still value in using the tool. That is, of course, if the CAPE is being used to assess valuations in the long term, not the short term.
Disclaimer: This review is based on the book, “Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market” by Mebane (Meb) Faber, published in 2014 by The Idea Farm. Unless otherwise noted, all ideas and opinions in this review are those of the author.
Read more here:
- Global Value: The CAPE Ratio
- Global Value: Bubbles and Emotions
- Global Value: A Look at Stock Market Bubbles
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