US

John Authers

Cyclically-adjusted price/earnings multiples (CAPEs), as made famous by Yale’s Professor Robert Shiller, are growing inconvenient for the brokerage community.

Last week, BofA Merrill Lynch’s Savita Subramanian pointed out that of 15 popular measures of equity valuation, CAPE (which compares share prices to a 10-year moving average of real earnings) was the only one that made stocks look expensive. The list of valuations suggesting US stocks are either cheap or at fair value includes:

  • trailing p/e
  • forward consensus p/e
  • trailing normalised p/e
  • price/book
  • enterprise value/ebitda
  • forward PEG (p/e ratio divided by growth)
  • trailing PEG
  • price/operating cash flow
  • price/free cash flow
  • enterprise value/sales
  • market-based equity risk premium
  • normalised equity risk premium
  • S&P 500 in WTI oil terms
  • and S&P 500 in gold terms

CAPE is thus beginning to stick out like a sore thumb. As it has been showing that stocks are expensive throughout most of the current rally, there is now a widening attempt to discredit or ignore it. Merrill’s own complaint is typical:

The Shiller P/E, which is based on inflation-adjusted earnings over the past 10 years, currently suggests that stocks are overvalued. However, this metric
assumes that the normalized (cyclically-adjusted) EPS for the S&P 500 is today less than $70—well below even our recessionary scenario for EPS. The
methodology assumes that the last 10 years is a representative sample, but the most recent profits recession was the worst we have seen and was exacerbated by a high leverage ratio which has since been dramatically reduced. Assuming that this scenario is going to repeat itself is, we think, overly pessimistic

But is it? Earnings volatility has certainly been extreme over the last decade, and arguably unprecedented. But if anything that suggests that the measure – which grew famous from efforts to predict the bursting of the dotcom bubble in 2000 and to show that the 2003-07 bull market was a “fools rally” – is more, not less, useful. That is the contention of Prof Shiller himself, and it is a reasonable one. More on this, with charts, and some comments from Prof Shiller, after the break. 

James Mackintosh

Former US Treasury Secretary Larry Summers warned of the dangers in the eurozone in his latest op-ed for the FT, and it is hard to disagree. But part of what he said bothered me:

A worrisome indicator in much of Europe is the tendency of stock and bond prices to move together. In healthy countries, when sentiment improves stock prices rise and bond prices fall, as risk premiums decline and interest rates rise. In unhealthy economies, as in much of Europe today, bonds are seen as risk assets, so they move just like stocks in response to changes in sentiment. 

James Mackintosh

To answer the question of who owns corporate America, we turn naturally enough to Goldman Sachs. In spite of all the “vampire squid” hype, the answer isn’t GS: but it does have an excellent summary of how ownership has changed (click on the chart for a bigger version).

Ownership of corporate America 

US GDP dropped in the fourth quarter of 2012 for the first time outside a recession since 1977, thanks to surprise cuts in defence spending. James Mackintosh, investment editor, finds some good signs in the data, but worries that if good news comes through on the economy would be bad news for investors.

 

Small caps in the US have hit their fifth new high of the year and UK smaller companies soared past their previous peak a month ago – both climbing 172 per cent since 2009. But James Mackintosh, investment editor, warns that if the current rally peters out small caps look particularly exposed.

 

Investors are becoming more hopeful that a deal will be done to avoid the US fiscal cliff. But would it really be so bad if no deal was reached? James Mackintosh, investment editor, explores the impact of the tax hikes and spending cuts due in the new year.

Consumer confidence in the US is climbing despite disposable incomes flatlining for five years, suggesting few worries about the looming fiscal cliff. James Mackintosh, investment editor, points out the worries among chief executives and warns that even if the fiscal cliff becomes a fiscal staircase, it could still be an uncomfortable climb down.

Reasons to be fearful are everywhere: Greece, triple-dip Japan and the looming fiscal cliff in the US. Yet, as James Mackintosh, investment editor, points out, share, bond and currency volatility are all extremely low. Is this complacency or have central banks disconnected the volatility sensors?

James Mackintosh

Market outlooks for the US election were clear: an Obama victory would be bad for shares and good for bonds, as the incumbent president would have less chance of cutting a deal with an intransigent Congress than his challenger.

Barack Obama would also be bad for the dollar, as there would be no pressure on the Federal Reserve from a hawkish Republican to tighten monetary policy, meaning the easiest monetary policy ever would remain in place. 

James Mackintosh

Even after the extraordinary summer rally in European equities, strategists continue to punt European shares as cheap, and so worth buying. Unfortunately, it’s more complicated than that.

The sell-side analysts pushing the idea are too numerous to list, but one of the better argued cases is that presented by the cyclically-adjusted price-earnings ratio (CAPE), which averages profits over 10 years in an attempt to eliminate the effects of the economic cycle.

Paul Jackson at Societe Generale has some nice charts showing Europe looks cheap, and demonstrating the use of one derivative of CAPE, the cyclically-adjusted dividend yield.

CAPE vs its average