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Hussman Funds: Does the CAPE Still Work?

December 24, 2013

It’s been a memorable few months for the CAPE (“cyclically-adjusted price/earnings”) ratio. Its developer – Robert Shiller – won a well-deserved Nobel Prize in economics back in October. The Nobel committee cited his early work showing that stock prices displayed “excess volatility:” the value obtained from discounting the cash flows provided to investors was more stable than the volatility of actual short-term price movements. This original work launched Shiller toward a career focused on asset valuation, investor behavior, and identifying bubbles. One tool that came out of that work was the Cyclically Adjusted P/E Ratio – the valuation ratio that compares the the S&P 500 Index to the 10-year average of inflation-adjusted earnings. Following this year’s accolades for its creator, an already well-known valuation metric has become even more widely known.

More recently the ratio has undergone an attack from some widely-followed analysts, questioning its validity and offering up attempts to adjust the ratio. This may be a reaction to its new-found notoriety, but more likely it’s because the CAPE is suggesting that US stocks are significantly overvalued. All of the adjustments analysts have made so far imply that stocks are less overvalued than the traditional CAPE would suggest.

We feel no particular obligation defend the CAPE ratio. It has a strong long-term relationship to subsequent 10-year market returns. And it’s only one of numerous valuation indicators that we use in our work – many which are considerably more reliable. All of these valuation indicators – particularly when record-high profit margins are accounted for – are sending the same message: The market is steeply overvalued, leaving investors with the prospect of low, single-digit long-term expected returns. But we decided to come to the aid of the CAPE ratio in this case because a few errors have slipped into the debate, and it’s important for investors who have previously relied on this ratio to understand these errors so they can judge the valuation metric fairly.

Importantly, the primary error that is being made is not even the fault of those making the arguments against the CAPE ratio. The fault lies at the feet of a misleading data series.

The Ingredients of the CAPE Ratio

A quick review of the historical progression of earnings may help with this discussion. Reportedearnings are profits that companies have historically reported, adhering to Generally Accepted Accounting Principles (GAAP). This is the longest data series available. Standard & Poor’s has reported earnings for the S&P 500 Index reaching back to 1936. Robert Shiller’s work has taken this data series back even further, to 1871.

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