Jeremy Siegel

John Authers

We all know that reported earnings are manipulated. But are they manipulated any more than they used to be, and are they manipulated so as to overstate profits, or understate them? And is the manipulation now so extreme that it is no longer relevant to compare profits over long periods of time? That is where the debate over CAPE (the cyclically adjusted price/earnings ratio) has reached. Even if it sounds technical, it is of vital importance when trying to work out whether the market is undervalued – as much of the stock broker community likes to argue – or in fact overvalue.

For those who missed them, the FT recently published my latest Long View column, defending the cyclically adjusted price/earnings ratio as calculated by Robert Shiller of Yale University and its relevance, quickly followed by a Market Insight column from Jeremy Siegel of the University of Pennsylvania’s Wharton School, and author of Stocks for the Long Run, arguing that Cape’s “overly pessimistic predictions are based on biased earnings data”. An academic conference on the subject is coming up in September.

Some navigation might be helpful. This is not just an arid academic dispute but a matter of critical interest to practising investors. As discussed last week, CAPE has been an impressive metric of value for over a century, and it sticks out from other metrics at present by signalling that stocks are badly overvalued (by 63 per cent for non-financials according to Andrew Smithers, a firm advocate of CAPEs as defined by Prof Shiller). Various different exchange-traded funds are now available that attempt to time switches between sectors based on their CAPE ratios.

However, the fact that CAPE is so bearish makes it unpopular. So does the undeniable fact that CAPE has been too bearish to be of great use to the average asset allocators over the last decade, failing to signal that stocks were cheap before two separate rallies, both of which saw stocks double over a period of four years. (You can see charts of CAPE over time in earlier LongShort posts here and here). Proponents of CAPE would counter that the measure is not for tactical asset allocation and that valuations cannot be used for timing the market.

So bulls are now trying to show either that Shiller’s CAPE was always flawed, or something has happened in the last decade or so to make the measure less useful. The academic participants know a lot of money is riding on this. Much more after the break.