Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
Topic Author
AlohaJoe
Posts: 4782
Joined: Mon Nov 26, 2007 2:00 pm
Location: Saigon, Vietnam

Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by AlohaJoe » Thu Aug 25, 2016 10:04 pm

Okay, "no-good horrible" is my paraphrase but he does call it the "least compelling" and "most dangerous" of all of Schiller's works: http://aswathdamodaran.blogspot.com/201 ... pe-it.html

I won't try to summarise all of his points, he isn't trying to prove that stocks are undervalued:
Am I making the case that stocks are under valued? If I did, I would be just as guilty as those who use CAPE to make the opposite case. I am not a market timer, by nature, and any single pricing metric, no matter how well reasoned it may be, is too weak to capture the complexity of the market.
But he certainly goes out of his way to suggest it is not even remotely clear that they are overvalued in any sense.

Image

Image

But maybe most usefully for the many, many, many posts on Bogleheads about "am I investing at the peak, what should I do" he provides a CAPE-based market timing spreadsheet so you can try your market timing ideas yourself and see how poorly they work out

http://www.stern.nyu.edu/~adamodar/pc/b ... iming.xlsx
Note that as you trust CAPE more and more (using lower thresholds and adjusting your equity allocation more), you do more and more damage to the end-value of your portfolio

User avatar
FIREchief
Posts: 3541
Joined: Fri Aug 19, 2016 6:40 pm

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by FIREchief » Thu Aug 25, 2016 10:25 pm

Aloha - thanks for posting that. I read through some of the link, but will admit that when it comes to CAPE 10, my attention span is severely limited. I just don't have any faith in such a high level, simple metric, being able to predict anything about future market returns. I know that some/many have built vast collections of books/speeches/papers/etc. on this stuff, but I ain't buying. I have no problem with "no-good horrible." :sharebeer
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.

Waba
Posts: 376
Joined: Wed Feb 26, 2014 9:19 pm

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by Waba » Thu Aug 25, 2016 10:31 pm

Just click-bait noise IMHO. He first claims that price/cash return is a better metric than price/earnings and then two paragraphs later he wonders how those buybacks can be sustainable when they exceed earnings.... DUH!

Topic Author
AlohaJoe
Posts: 4782
Joined: Mon Nov 26, 2007 2:00 pm
Location: Saigon, Vietnam

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by AlohaJoe » Thu Aug 25, 2016 10:49 pm

Waba wrote:He first claims that price/cash return is a better metric than price/earnings
I missed the part where he makes that claim. Could you quote it here for me and other readers? Thanks!

pascalwager
Posts: 1542
Joined: Mon Oct 31, 2011 8:36 pm

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by pascalwager » Fri Aug 26, 2016 11:55 am

Not a passive investor. Isn't satisfied with future market returns and picks companies.

User avatar
unclescrooge
Posts: 3760
Joined: Thu Jun 07, 2012 7:00 pm

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by unclescrooge » Fri Aug 26, 2016 12:43 pm

Waba wrote:Just click-bait noise IMHO. He first claims that price/cash return is a better metric than price/earnings and then two paragraphs later he wonders how those buybacks can be sustainable when they exceed earnings.... DUH!
I fail to see how this is click bait.

User avatar
unclescrooge
Posts: 3760
Joined: Thu Jun 07, 2012 7:00 pm

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by unclescrooge » Fri Aug 26, 2016 12:45 pm

AlohaJoe wrote:Okay, "no-good horrible" is my paraphrase but he does call it the "least compelling" and "most dangerous" of all of Schiller's works: http://aswathdamodaran.blogspot.com/201 ... pe-it.html

I won't try to summarise all of his points, he isn't trying to prove that stocks are undervalued:
Am I making the case that stocks are under valued? If I did, I would be just as guilty as those who use CAPE to make the opposite case. I am not a market timer, by nature, and any single pricing metric, no matter how well reasoned it may be, is too weak to capture the complexity of the market.
But he certainly goes out of his way to suggest it is not even remotely clear that they are overvalued in any sense.

Image

Image

But maybe most usefully for the many, many, many posts on Bogleheads about "am I investing at the peak, what should I do" he provides a CAPE-based market timing spreadsheet so you can try your market timing ideas yourself and see how poorly they work out

http://www.stern.nyu.edu/~adamodar/pc/b ... iming.xlsx
Note that as you trust CAPE more and more (using lower thresholds and adjusting your equity allocation more), you do more and more damage to the end-value of your portfolio
Thanks for posting! I particularly enjoyed his spreadsheet about using CAPE ad a market timing tool.

garlandwhizzer
Posts: 2436
Joined: Fri Aug 06, 2010 3:42 pm

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by garlandwhizzer » Fri Aug 26, 2016 1:18 pm

The fact that CAPE 10 looks high now suggests but does not prove that equity returns over the next decade will be lower than in the long term historical past. The fact that ratios of earnings yields between bonds or cash on the one hand and CAPE 10 on the other look normal does not imply that equities are expected to produce historical results. Rather it suggests that expected returns on bond and cash going forward are at least as depressed relative to history as are stock returns. What it says is that all expected returns--stocks, bonds, cash--are expected to similarly depressed over the next decade or so. It does not suggest switching from stocks to bonds based on a high current level of CAPE 10, nor does it suggest switching from bonds to stocks based on historically low bond yields. What it does suggest is: work longer, save and invest more, control expenses, and maintain patience over the long haul because it's going to be a long haul. Getting rich quickly does not appear to be a likely option for US investors today.

Garland Whizzer

User avatar
unclescrooge
Posts: 3760
Joined: Thu Jun 07, 2012 7:00 pm

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by unclescrooge » Fri Aug 26, 2016 1:39 pm

garlandwhizzer wrote:The fact that CAPE 10 looks high now suggests but does not prove that equity returns over the next decade will be lower than in the long term historical past. The fact that ratios of earnings yields between bonds or cash on the one hand and CAPE 10 on the other look normal does not imply that equities are expected to produce historical results. Rather it suggests that expected returns on bond and cash going forward are at least as depressed relative to history as are stock returns. What it says is that all expected returns--stocks, bonds, cash--are expected to similarly depressed over the next decade or so. It does not suggest switching from stocks to bonds based on a high current level of CAPE 10, nor does it suggest switching from bonds to stocks based on historically low bond yields. What it does suggest is: work longer, save and invest more, control expenses, and maintain patience over the long haul because it's going to be a long haul. Getting rich quickly does not appear to be a likely option for US investors today.

Garland Whizzer
+1

Thank you for this synopsis.

larryswedroe
Posts: 15988
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by larryswedroe » Fri Aug 26, 2016 8:19 pm

Garland
Exactly. Also there is no evidence one can use CAPE 10 for timing even though IMO it does provide important information about expected returns, just as current earning does, or CAPE 5 or CAPE 8, nothing magically about CAPE 10, And it says nothing about market being under or overvalued.
Larry

User avatar
g$$
Posts: 452
Joined: Wed Dec 21, 2011 12:17 am
Location: San Francisco

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by g$$ » Sat Aug 27, 2016 5:36 pm

Waba wrote:Just click-bait noise IMHO. He first claims that price/cash return is a better metric than price/earnings and then two paragraphs later he wonders how those buybacks can be sustainable when they exceed earnings.... DUH!
I disagree with the notion that Damodaran's blog (and this post in particular) can be considered "click-bait noise". His website is filled with original content has no adds. He provides references and useful tools for others to double-check his work. If there is anyone qualified to make claims about how to value a company, this is probably the guy.

-g$$

mako171
Posts: 73
Joined: Wed Dec 03, 2008 1:18 pm

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by mako171 » Sat Aug 27, 2016 6:41 pm

Damodaran is not click bait.

Waba
Posts: 376
Joined: Wed Feb 26, 2014 9:19 pm

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by Waba » Sat Aug 27, 2016 10:54 pm

AlohaJoe wrote:
Waba wrote:He first claims that price/cash return is a better metric than price/earnings
I missed the part where he makes that claim. Could you quote it here for me and other readers? Thanks!
"Its cash flow, not earnings that drives stocks"

Waba
Posts: 376
Joined: Wed Feb 26, 2014 9:19 pm

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by Waba » Sat Aug 27, 2016 11:17 pm

g$$ wrote:
Waba wrote:Just click-bait noise IMHO. He first claims that price/cash return is a better metric than price/earnings and then two paragraphs later he wonders how those buybacks can be sustainable when they exceed earnings.... DUH!
I disagree with the notion that Damodaran's blog (and this post in particular) can be considered "click-bait noise". His website is filled with original content has no adds. He provides references and useful tools for others to double-check his work. If there is anyone qualified to make claims about how to value a company, this is probably the guy.

-g$$
I dont argue with your description of his work, but I consider any post with "superman" and "kryptonite" in the title click-bait along the same lines as any market related article that is being accompanied by a picture of a burning zeppelin.

I consider it noise, in the Bogle sense of the word, because the article is essentially an opinion about current market valuation.

User avatar
unclescrooge
Posts: 3760
Joined: Thu Jun 07, 2012 7:00 pm

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by unclescrooge » Sun Aug 28, 2016 12:21 am

Waba wrote:
g$$ wrote:
Waba wrote:Just click-bait noise IMHO. He first claims that price/cash return is a better metric than price/earnings and then two paragraphs later he wonders how those buybacks can be sustainable when they exceed earnings.... DUH!
I disagree with the notion that Damodaran's blog (and this post in particular) can be considered "click-bait noise". His website is filled with original content has no adds. He provides references and useful tools for others to double-check his work. If there is anyone qualified to make claims about how to value a company, this is probably the guy.

-g$$
I dont argue with your description of his work, but I consider any post with "superman" and "kryptonite" in the title click-bait along the same lines as any market related article that is being accompanied by a picture of a burning zeppelin.

I consider it noise, in the Bogle sense of the word, because the article is essentially an opinion about current market valuation.
That's fair, assuming you have a better blog.

Otherwise it just sounds like sour grapes. :mrgreen:

Waba
Posts: 376
Joined: Wed Feb 26, 2014 9:19 pm

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by Waba » Sun Aug 28, 2016 2:46 pm

I can recommend this one for some sunday reading: http://blog.alphaarchitect.com

Northern Flicker
Posts: 4765
Joined: Fri Apr 10, 2015 12:29 am

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by Northern Flicker » Sun Aug 28, 2016 9:39 pm

If you believe in the efficient market hypothesis (and many people don't) a lower CAPE would mean a lower probability of projected earnings materializing leading to a higher discount rate or equity risk premium, but not a higher expected return due to the lower probability of achieving the higher revenue stream.

User avatar
Phineas J. Whoopee
Posts: 8627
Joined: Sun Dec 18, 2011 6:18 pm

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by Phineas J. Whoopee » Sun Aug 28, 2016 9:51 pm

jalbert wrote:If you believe in the efficient market hypothesis (and many people don't) a lower CAPE would mean a lower probability of projected earnings materializing leading to a higher discount rate or equity risk premium, but not a higher expected return due to the lower probability of achieving the higher revenue stream.
In what way does the efficient market hypothesis predict that?
PJW

Northern Flicker
Posts: 4765
Joined: Fri Apr 10, 2015 12:29 am

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by Northern Flicker » Mon Aug 29, 2016 2:40 am

If all public information about a stock is discounted into the price, then a different equity risk premium from the market average reflects a different level of risk that the future return or revenue would materialize. Otherwise, if a stock had a CAPE below the market CAPE, but had the same probability of future revenues materializing as the broad market, then the EMH would posit that this information would be priced in efficiently by the market action increasing the price until the equity risk premium for this stock was commensurate with the market's view of the probability of its future revenues materializing.

cjking
Posts: 1863
Joined: Mon Jun 30, 2008 4:30 am

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by cjking » Mon Aug 29, 2016 11:07 am

Notwithstanding its weak spots, let’s take the CAPE as your measure of stock market valuation. Is a CAPE of 27.27 too high, especially when the historic norm is closer to 16? The answer to you may sound obvious, but before you do answer, you have to consider where you would put your money instead. If you choose not to buy stocks...
So, if you feel US stocks with an earnings yield (1/CAPE) of 3.9% are too expensive, then the alternative is to shun stocks. Buying a world-ex-USA fund with earnings yield 6.2% is not an option to be considered. :confused

(I have US CAPE at 25.8, in case anyone is wondering why the yield above isn't 1/27.27.)

Incidentally, 1/6.2% = 16, i.e. the world-ex-USA fund has a CAPE value that matches his definition of reasonable value.

junior
Posts: 841
Joined: Wed Sep 10, 2008 6:14 pm
Contact:

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by junior » Mon Aug 29, 2016 11:34 am

cjking wrote: So, if you feel US stocks with an earnings yield (1/CAPE) of 3.9% are too expensive, then the alternative is to shun stocks. Buying a world-ex-USA fund with earnings yield 6.2% is not an option to be considered. :confused
Right. The strategy he "tested" is not one anyone would actually use in the real world, so I don't see the blog post as useful.

For me, I'm considering bi-annual rebalancing between stocks and bonds and adjusting the equity allocation up or down 10% or so based on CAPE at the time of rebalancing. Whether or not this is a good idea or not seems to be beyond the scope of the blog post.

michaeljc70
Posts: 5548
Joined: Thu Oct 15, 2015 3:53 pm

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by michaeljc70 » Mon Aug 29, 2016 4:03 pm

I have long believed that what a companies earned 10 years ago has almost zero impact on its valuation today. I just cannot grasp the logic. I understand the smoothing of the business cycle. Business cycles tend to be shorter than 10 years.

roflwaffle
Posts: 440
Joined: Mon Mar 02, 2015 10:08 pm

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by roflwaffle » Mon Aug 29, 2016 8:28 pm

I agree completely about CAPE alone being difficult to compare across decades, possibly because it's looking at pre-tax instead of post-tax earnings.

:beer

cjking
Posts: 1863
Joined: Mon Jun 30, 2008 4:30 am

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by cjking » Tue Aug 30, 2016 2:25 am

michaeljc70 wrote:I have long believed that what a companies earned 10 years ago has almost zero impact on its valuation today. I just cannot grasp the logic. I understand the smoothing of the business cycle. Business cycles tend to be shorter than 10 years.
I think past discussion on this issue has concluded that it doesn't make a lot of difference how many past years you use, within reason. Something like PE8 or PE7 might give better predictions, but the difference between them and PE10 is too small to worry about.

cjking
Posts: 1863
Joined: Mon Jun 30, 2008 4:30 am

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by cjking » Tue Aug 30, 2016 2:33 am

roflwaffle wrote:I agree completely about CAPE alone being difficult to compare across decades, possibly because it's looking at pre-tax instead of post-tax earnings.

:beer
Comparing CAPE to its past is open to an infinity of objections of a similar kind to that, fortunately most of the predictive ability can be had without comparing across decades.

User avatar
grayfox
Posts: 5184
Joined: Sat Sep 15, 2007 4:30 am

Re: Damodaran: CAPE is no-good horrible & a market timing spreadsheet

Post by grayfox » Tue Aug 30, 2016 4:28 am

AlohaJoe wrote:Okay, "no-good horrible" is my paraphrase but he does call it the "least compelling" and "most dangerous" of all of Schiller's works: http://aswathdamodaran.blogspot.com/201 ... pe-it.html
I found it more effective to watch the video rather than read the blog. You can study the figures and hear the audio text at the same time, increasing the data rate by using multiple com ports. Some comments about his points:

1. It's not that informative.
P/E10 and P/E1 may be similar, but during recessions when earnings temporarily collapse, P/E1 breaks down while P/E10 continues to inform. The idea is that an N-Year moving average provides a proxy of Permanent Earnings.

2. Not that predictive.
He only looks at predicting 1-year and 5-year returns. This is silly. Might as well look at 1-month or 1-day return.
Stocks are a long-term investment. The stock market is almost unpredictable at 1 year. Predicting 5-year returns is only a little better.
P/E10 model is most effective at predicting 20-year returns +/-4%. Even 10-year is less predictable, about +/-8%. 30-year returns are less dependent on P/E10, and very long term, say 50-100+ years does not really dependent on current valuations.

2b. A more direct test
Strawman. Informed Bogleheads have known for at least 10+ years that P/E10 is not useful for market timing, switching in and out of stocks. Maybe the rest of the world has not figured this out yet.

3. Investing is relative
Again, Bogleheads have known for 10+ years that you should compare E10/P with TIPS rate over the holding period.
In 2016, when 2040 TIPS are yielding 0.5% real, E10/P = 3.7% offers a large ERP.
In 2000, when TIPS were yielding 4% real and S&P500 E10/P was 2.5%, there was no ERP. TIPS had higher guaranteed real return than the expected return of S&P500.

4. It's the cash, not the earnings
Compares P/E to P/(Div+Buybacks). Fine. But P/E10 is easy to find with data going back to 1871. Where do you look up Buybacks, current and historical? I will sticks with looking at Reported Earnings, which are easy to find online.

Post Reply