Larry Swedroe: This Metric In Dire Need Of Context

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Larry Swedroe: This Metric In Dire Need Of Context

Postby Random Walker » Fri Jul 14, 2017 7:33 am

http://www.etf.com/sections/index-inves ... ed-context

Larry discusses CAPE 10, and why there are several reasons why it may not be as high relative to its historical average as it appears.

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Re: Larry Swedroe: This Metric In Dire Need Of Context

Postby dwickenh » Fri Jul 14, 2017 7:46 am

Thanks for linking.

Larry makes some interesting points in the article. Use of Cape 10 as a market timing tool is laid to rest.

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Re: Larry Swedroe: This Metric In Dire Need Of Context

Postby nedsaid » Fri Jul 14, 2017 9:06 am

As normal, a very good article from Larry. I am not panicking and selling my stops. The thing is, I didn't even know what the Schiller P/E 10 was until I read about it here. I had never heard it discussed on financial TV shows, seen discussions of it in financial publications, or heard anyone I respected talk about it. I had some fun with this, poking fun, asking how a metric that I had not heard of before could be an infallible market indicator. I had heard of Schiller, but in the context of real estate, and his valuation metric of the real estate market.

My reaction is sort of like the Hindenburg omen, whatever that was. The indicator flashed bearish, Oh the Humanity, and the market shot up.

P/E 10 is a good and useful concept, as I would say, a tool in the toolbox. But to hear some folks here, it came down from Mt. Sinai carried by Moses with the 10 commandments. Or that it came over with the Mayflower.

I am not arguing that stocks are cheap. Pretty much, I have said that valuations are "stretched" but not irrationally so, particularly in light of very low interest rates. Higher market P/E's have not happened in a vacuum.
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Re: Larry Swedroe: This Metric In Dire Need Of Context

Postby Theoretical » Sat Jul 15, 2017 6:17 pm

Something I think Larry's article highlights is that it's only PE that's elevated and not the other metrics like sales, dividend yield (! -that's actually huge considering the yield chasing of the last decade and increased buybacks), or cash flows. If all of them were in the nosebleed section, I'd be more worried.

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Re: Larry Swedroe: This Metric In Dire Need Of Context

Postby Grt2bOutdoors » Sat Jul 15, 2017 6:42 pm

Another good read. Keep them coming Larry. Thanks for posting link. :beer
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Re: Larry Swedroe: This Metric In Dire Need Of Context

Postby Valuethinker » Sun Jul 16, 2017 9:32 am

nedsaid wrote:As normal, a very good article from Larry. I am not panicking and selling my stops. The thing is, I didn't even know what the Schiller P/E 10 was until I read about it here. I had never heard it discussed on financial TV shows, seen discussions of it in financial publications, or heard anyone I respected talk about it. I had some fun with this, poking fun, asking how a metric that I had not heard of before could be an infallible market indicator. I had heard of Schiller, but in the context of real estate, and his valuation metric of the real estate market.

My reaction is sort of like the Hindenburg omen, whatever that was. The indicator flashed bearish, Oh the Humanity, and the market shot up.


I think you've made a false analogy? Have you read Irrational Exuberance? Particularly the First Edition (which called the dot com bubble).

The Shiller PE 10 flashed a huge warning sign in the late 1990s when the first edition of Irrational Exuberance came out. Duly, since then, equity markets have performed poorly.

What is different, see GMO, is that corporate profit margins have kept rising to historically high levels. A lot of evidence this is due to the emergence of super champions, companies which totally dominate their competitive spaces. Technology is the clearest example: Google, Apple, Facebook etc. But also in other areas such as healthcare (Pfizer, J&J etc), Beer (InBev), banking (JP Morgan), insurance (Berkshire Hathway), railways (ditto), airlines etc.

And companies have kept buying back shares-- there has probably been net equity retirement since 2000, partly due to the explosion of the leveraged buyout industry (take private transactions in particular) which is probably at least 5x the size it was in 2000.

P/E 10 is a good and useful concept, as I would say, a tool in the toolbox. But to hear some folks here, it came down from Mt. Sinai carried by Moses with the 10 commandments. Or that it came over with the Mayflower.

I am not arguing that stocks are cheap. Pretty much, I have said that valuations are "stretched" but not irrationally so, particularly in light of very low interest rates. Higher market P/E's have not happened in a vacuum.


The point is that it made a very good call, up to 2000, and did so with good intellectual reasoning behind it. As GMO pointed out (one of J Grantham's recent letters) the "reversion to the mean" of corporate profitability did not happen post 2000*. The bubble expired, equity returns have been reasonably mediocre, but higher margins plus a predisposition to buy back shares, do justify a higher PE. (it's also the high point of value investing, because it turned out it was the Tech Media Telecoms industry (Enron & Worldcom & Nortel in particular) that was in a huge bubble, and much of the rest of the stock market was not, and value strategies captured that in 2001-6 i.e. the trick was to be out of those sectors).

By 2005 say we had companies like Google & later Apple and Facebook which could skim off a seemingly ever increasing portion of the total corporate profit pool (Amazon is more of a puzzle, but if you strip out investment then it's pretty profitable, but it's an open question whether it is legitimate to do that). Apple has both, since 2007, managed to sell c. 1.2 billion iphones (say $750- 1 trilloin of revenue) *and* make hundreds of billions of profit on that.

* it turned out that much of the "profits" of the financial services sector 2002-07 was absolutely mythical. A product of vastly overinflated markets rather than a real economic return on capital invested. That excess was then obliterated in a vast sea of one off earnings charges and asset writedowns, and in bankruptcy in some cases, or outright socialization of losses (FNMA, FMAC, RBS, HBOS etc.).

It's an interesting call whether those record profits, now, are more substantial or just a product of another burgeoning asset bubble (s).

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Re: Larry Swedroe: This Metric In Dire Need Of Context

Postby nedsaid » Sun Jul 16, 2017 10:15 am

Valuethinker wrote:
nedsaid wrote:As normal, a very good article from Larry. I am not panicking and selling my stops. The thing is, I didn't even know what the Schiller P/E 10 was until I read about it here. I had never heard it discussed on financial TV shows, seen discussions of it in financial publications, or heard anyone I respected talk about it. I had some fun with this, poking fun, asking how a metric that I had not heard of before could be an infallible market indicator. I had heard of Schiller, but in the context of real estate, and his valuation metric of the real estate market.

My reaction is sort of like the Hindenburg omen, whatever that was. The indicator flashed bearish, Oh the Humanity, and the market shot up.


I think you've made a false analogy? Have you read Irrational Exuberance? Particularly the First Edition (which called the dot com bubble).

Nedsaid: Valuethinker, are you serious? The market does not have the feel of the late 1990's, indeed the more the market goes up, the more pessimism that we see. OMG, we are going to crash! I see a lot of negative articles out there. Not the euphoria of early 2000, when it seemed like the NASDAQ went up 100 points a day.

I certainly don't argue that the market is cheap. Last I looked, forward P/E's were almost 20 and trailing P/E's about 26 or 27. Compare this to early 2000, when forward P/E's for the US Market got to be about 32 and trailing P/E's 45. This is not the late 2000's. (Edit: Mistype. I meant the late 1990's.) Another factor is that interest rates are much lower than then.


The Shiller PE 10 flashed a huge warning sign in the late 1990s when the first edition of Irrational Exuberance came out. Duly, since then, equity markets have performed poorly.

Nedsaid: Elaine Garzarelli predicted the 1987 crash and then was mostly wrong afterwards. Bob Brinker correctly called the 2000-2002 bear market and then ruined his market timing record with his infamous QQQ call. I think attributing infallibility to Shiller is a similar mistake.

The late 1990's was a true mania. The US Market compounded at something like 27% from 1995 through early 2000. We are not seeing that today.


What is different, see GMO, is that corporate profit margins have kept rising to historically high levels. A lot of evidence this is due to the emergence of super champions, companies which totally dominate their competitive spaces. Technology is the clearest example: Google, Apple, Facebook etc. But also in other areas such as healthcare (Pfizer, J&J etc), Beer (InBev), banking (JP Morgan), insurance (Berkshire Hathway), railways (ditto), airlines etc.

And companies have kept buying back shares-- there has probably been net equity retirement since 2000, partly due to the explosion of the leveraged buyout industry (take private transactions in particular) which is probably at least 5x the size it was in 2000.

Nedsaid: Yes, I am aware that profit margins are historically high. This is testament to how utterly ruthless American business is, the answer to pretty much anything is to lay off employees. I think these margins will fall at some point which is why investors should be looking overseas for better values.

P/E 10 is a good and useful concept, as I would say, a tool in the toolbox. But to hear some folks here, it came down from Mt. Sinai carried by Moses with the 10 commandments. Or that it came over with the Mayflower.

I am not arguing that stocks are cheap. Pretty much, I have said that valuations are "stretched" but not irrationally so, particularly in light of very low interest rates. Higher market P/E's have not happened in a vacuum.


The point is that it made a very good call, up to 2000, and did so with good intellectual reasoning behind it. As GMO pointed out (one of J Grantham's recent letters) the "reversion to the mean" of corporate profitability did not happen post 2000*. The bubble expired, equity returns have been reasonably mediocre, but higher margins plus a predisposition to buy back shares, do justify a higher PE. (it's also the high point of value investing, because it turned out it was the Tech Media Telecoms industry (Enron & Worldcom & Nortel in particular) that was in a huge bubble, and much of the rest of the stock market was not, and value strategies captured that in 2001-6 i.e. the trick was to be out of those sectors).

Nedsaid: Almost every market call has good intellectual reasoning behind it and over time most market calls turn out to be wrong, just like economic predictions. You are putting too many eggs in the Shiller basket.

Schiller is right that valuations give you a good indication of future expected returns. John Bogle expects stock market returns to be rather subdued, in part because he believes that P/E ratios over time will shrink. Last I read, Bogle is projecting 4% maybe 5% nominal returns for the US market.


By 2005 say we had companies like Google & later Apple and Facebook which could skim off a seemingly ever increasing portion of the total corporate profit pool (Amazon is more of a puzzle, but if you strip out investment then it's pretty profitable, but it's an open question whether it is legitimate to do that). Apple has both, since 2007, managed to sell c. 1.2 billion iphones (say $750- 1 trilloin of revenue) *and* make hundreds of billions of profit on that.

* it turned out that much of the "profits" of the financial services sector 2002-07 was absolutely mythical. A product of vastly overinflated markets rather than a real economic return on capital invested. That excess was then obliterated in a vast sea of one off earnings charges and asset writedowns, and in bankruptcy in some cases, or outright socialization of losses (FNMA, FMAC, RBS, HBOS etc.).

Nedsaid: Another thing that Larry Swedroe has addressed is that Generally Accepted Accounting Principles have become more conservative over time. My off the top of my head guess is that forward earnings by 1970 GAAP would be more like 15 or 16 P/E rather than 20.

Again, I am not saying the US Market is cheap. I believe valuations to be "stretched" but not irrationally so. Warren Buffett believes the US Market to be reasonably priced, particularly in light of very low interest rates. I have been suggesting that US investors look overseas for better values but not to abandon the US Market. This is not the late 1990's and your post is good evidence of that.


It's an interesting call whether those record profits, now, are more substantial or just a product of another burgeoning asset bubble (s).
Last edited by nedsaid on Mon Jul 17, 2017 11:26 am, edited 1 time in total.
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Re: Larry Swedroe: This Metric In Dire Need Of Context

Postby Valuethinker » Sun Jul 16, 2017 11:46 am

nedsaid wrote:
Valuethinker wrote:
nedsaid wrote:As normal, a very good article from Larry. I am not panicking and selling my stops. The thing is, I didn't even know what the Schiller P/E 10 was until I read about it here. I had never heard it discussed on financial TV shows, seen discussions of it in financial publications, or heard anyone I respected talk about it. I had some fun with this, poking fun, asking how a metric that I had not heard of before could be an infallible market indicator. I had heard of Schiller, but in the context of real estate, and his valuation metric of the real estate market.

My reaction is sort of like the Hindenburg omen, whatever that was. The indicator flashed bearish, Oh the Humanity, and the market shot up.


I think you've made a false analogy? Have you read Irrational Exuberance? Particularly the First Edition (which called the dot com bubble).

Nedsaid: Valuethinker, are you serious? The market does not have the feel of the late 1990's, indeed the more the market goes up, the more pessimism that we see. OMG, we are going to crash! I see a lot of negative articles out there. Not the euphoria of early 2000, when it seemed like the NASDAQ went up 100 points a day.

I certainly don't argue that the market is cheap. Last I looked, forward P/E's were almost 20 and trailing P/E's about 26 or 27. Compare this to early 2000, when forward P/E's for the US Market got to be about 32 and trailing P/E's 45. This is not the late 2000's. Another factor is that interest rates are much lower than then.


I'm confused. Are you arguing the Shiller PE 10 is irrelevant, or that it is not calling a market "sell" signal now?

How is this Shiller PE 10 like the Hindenburg Omen?


The Shiller PE 10 flashed a huge warning sign in the late 1990s when the first edition of Irrational Exuberance came out. Duly, since then, equity markets have performed poorly.

Nedsaid: Elaine Garzarelli predicted the 1987 crash and then was mostly wrong afterwards. Bob Brinker correctly called the 2000-2002 bear market and then ruined his market timing record with his infamous QQQ call. I think attributing infallibility to Shiller is a similar mistake.

The late 1990's was a true mania. The US Market compounded at something like 27% from 1995 through early 2000. We are not seeing that today.



But the metric, which had an intellectual logic to it, worked. In other words, valuation did matter.

Garzarelli, Brinker- -these are not proper analogies. They are not theories. They are individuals.

What is different, see GMO, is that corporate profit margins have kept rising to historically high levels. A lot of evidence this is due to the emergence of super champions, companies which totally dominate their competitive spaces. Technology is the clearest example: Google, Apple, Facebook etc. But also in other areas such as healthcare (Pfizer, J&J etc), Beer (InBev), banking (JP Morgan), insurance (Berkshire Hathway), railways (ditto), airlines etc.

And companies have kept buying back shares-- there has probably been net equity retirement since 2000, partly due to the explosion of the leveraged buyout industry (take private transactions in particular) which is probably at least 5x the size it was in 2000.

Nedsaid: Yes, I am aware that profit margins are historically high. This is testament to how utterly ruthless American business is, the answer to pretty much anything is to lay off employees. I think these margins will fall at some point which is why investors should be looking overseas for better values.


I don't think your explanation is correct, or entire. American companies can afford to lay people off because US labour laws are very lax compared to most other countries (in developed markets). I have experienced here how difficult they find it, conceptually, to understand legally mandated consultation periods & employee rights in termination-- those concepts don't seem to exist in the US, generally.

But you perhaps do not remember the early 1990s era of Business Process Reengineering (CSC Index was the firm which became huge on this)? BPR, aka aggressive cost cutting, was practiced by many many large companies. And the stock market cheered with each notice of major layoffs. And it turned out not to be a source of lasting competitive advantage. Studies showed those companies subsequently underperformed.

Nobody talks about BPR now.

Rather, I think there are 3 or 4 factors:

1. is the cessation of aggressive antitrust enforcement, particularly by US regulatory authorities. This started in the 1980s but the predominant ideology of the 1990s and 2000s was "laisser faire". As a result, on most metrics, concentration of US industries has increased significantly-- consider airlines, telecoms, insurance, pharmaceuticals, media etc. Or business software (Oracle in particular).

We are actually as close as we have been in 100 years to the "trust buster" era where there were oligopolists and monopolists in many major parts of American life, and Teddy Roosevelt etc. came in and broke them up.

The US is of course not alone in this. Although European authorities have been more aggressive, generally across the world since 1980 laisser-faire has been the more predominant philosophy, and you have seen, with globalization, the emergence of these supercompanies

https://www.newamerica.org/open-markets ... r-reading/

gives a long list of readings on this phenomenon/ thesis. I am sure Marginal Revolution blog (which I am sure you read?) has discussed it of late.

2. I've seen quite a bit of commentary recently on the degree to which the Michael Porter analysis of industries and competition (he first published Competitive Strategy in 1979) has been taken to heart by large companies. Which is unsurprising, because his work is taught in every first year MBA curriculum, and the last 40 years has seen the era of the MBA in business-- the number of MBAs worldwide has probably risen 100-fold, and we have also seen the rise and rise of the large strategy consultancies, whose predominant tool is *still* the 5 Forces and ancillary intellectual developments.

In other words, companies are doing just what their strategic advisors and B School professors told them to do.

The shareholder value movement (Michael Jensen, another HBS professor) has also taken over in much of the world's business. And that, also, speaks to concentration, focus, ruthless sale of non core assets to industry aggregators.

3. The interesting part is the split between 1, 2 & 3. 3 is the rise and rise of technology- -the merger of new communications means (the internet) with new technologies (the desktop computer, the smartphone). This is genuinely disruptive change and the companies which have dominated it are making huge returns on capital. Industries like Search have (apparently) infinitely increasing returns to scale - Google. That leads you to natural monopolies. It remains to be seen whether Amazon manages it (they have totally dominated some verticals eg book retail) but their constant reinvestment makes it hard to track whether they are actually exerting monopoly power. What they are doing is obliterating competition. But desktop software (Microsoft), enterprise software (Oracle), semiconductors (TSMC, Intel, TI, Samsung). Apple is of course the example to prove all examples-- they have sold 1.2 billion iphones in 10 years, for total revenues of over $700bn and profits in the hundreds of billions.

Google. Facebook. Netflix (maybe). These companies just dominate their markets completely. Something like 80% of all digital advertising goes through Google or Facebook-- worldwide-- I believe that I read.

4. In the balance of power between labour and capital, capital has won hands down since 1980. Trade unionization has fallen in almost every major country, and in some, like the USA, it's become almost unknown in the private sector (only about 11% of employees in US private sector are unionized).

But that shift has taken place in other countries besides the USA. e.g. the UK and Canada. And even in Europe, private sector unions are far more quiescent than they were in the 1970s. A lot of this has to do with globalization and the attendant competitive pressures.

I think the very interesting conclusion of this is that number 4, something we (I) was taught in undergrad economics was just not relevant, turns out to maybe have been (a) key part of the story.


P/E 10 is a good and useful concept, as I would say, a tool in the toolbox. But to hear some folks here, it came down from Mt. Sinai carried by Moses with the 10 commandments. Or that it came over with the Mayflower.

I am not arguing that stocks are cheap. Pretty much, I have said that valuations are "stretched" but not irrationally so, particularly in light of very low interest rates. Higher market P/E's have not happened in a vacuum.


The point is that it made a very good call, up to 2000, and did so with good intellectual reasoning behind it. As GMO pointed out (one of J Grantham's recent letters) the "reversion to the mean" of corporate profitability did not happen post 2000*. The bubble expired, equity returns have been reasonably mediocre, but higher margins plus a predisposition to buy back shares, do justify a higher PE. (it's also the high point of value investing, because it turned out it was the Tech Media Telecoms industry (Enron & Worldcom & Nortel in particular) that was in a huge bubble, and much of the rest of the stock market was not, and value strategies captured that in 2001-6 i.e. the trick was to be out of those sectors).

Nedsaid: Almost every market call has good intellectual reasoning behind it and over time most market calls turn out to be wrong, just like economic predictions. You are putting too many eggs in the Shiller basket.

Schiller is right that valuations give you a good indication of future expected returns. John Bogle expects stock market returns to be rather subdued, in part because he believes that P/E ratios over time will shrink. Last I read, Bogle is projecting 4% maybe 5% nominal returns for the US market.


OK I am confused again.

Is Shiller a kind of snake oil like the the Hindenburg Omen (Cross)? Or a useful tool?

You seem to have set up a kind of Straw Man, that Shiller PE10 is 1). the only guide to valuation out there 2). is unambiguously sending a "sell" signal? What it actually seems to be sending is a signal that equity returns are quite likely to be modest from here. Unfortunately, so are the returns from everything else, and most especially bonds.

Interestingly Andrew Smithers (of Valuing Wall Street fame, another famous bearish book of that era) uses price to book (a modified version of Tobin's Q, ratio of stock market values to replacement values of assets) says something similar, now (he spent quite a bit of time demolishing other metrics of value, and concluding that PE10 was really, at best, his valuation metric).

http://www.smithers.co.uk/page.php?id=50 if you follow through the link to the spreadsheet, it shows Q and CAPE to be in about the same place, i.e. that US markets are about as expensive as they have ever been *other than* 2000 and 1929 (and about as expensive as late 1960s).

By 2005 say we had companies like Google & later Apple and Facebook which could skim off a seemingly ever increasing portion of the total corporate profit pool (Amazon is more of a puzzle, but if you strip out investment then it's pretty profitable, but it's an open question whether it is legitimate to do that). Apple has both, since 2007, managed to sell c. 1.2 billion iphones (say $750- 1 trilloin of revenue) *and* make hundreds of billions of profit on that.

* it turned out that much of the "profits" of the financial services sector 2002-07 was absolutely mythical. A product of vastly overinflated markets rather than a real economic return on capital invested. That excess was then obliterated in a vast sea of one off earnings charges and asset writedowns, and in bankruptcy in some cases, or outright socialization of losses (FNMA, FMAC, RBS, HBOS etc.).

Nedsaid: Another thing that Larry Swedroe has addressed is that Generally Accepted Accounting Principles have become more conservative over time. My off the top of my head guess is that forward earnings by 1970 GAAP would be more like 15 or 16 P/E rather than 20.

Again, I am not saying the US Market is cheap. I believe valuations to be "stretched" but not irrationally so. Warren Buffett believes the US Market to be reasonably priced, particularly in light of very low interest rates. I have been suggesting that US investors look overseas for better values but not to abandon the US Market. This is not the late 1990's and your post is good evidence of that.


It's an interesting call whether those record profits, now, are more substantial or just a product of another burgeoning asset bubble (s).
[/quote][/quote]

I can't get my head around the GAAP argument at the moment. One issue is the rest of the world doesn't use US GAAP, and that might mean that overseas earnings are overstated.

Also though the question of greater conservatism. Not sure I know enough about the subject. Post Enron, things like accounting for stock options in profits & EPS were introduced. But, conversely, go back to the 1970s and the volumes of stock options issued were far, far less.

I think the main issue is we have not done away with volatility. Yes interest rates seem to be (for the forseeable future) much lower than historic. But we haven't ended the problem of corporate profitability cyclicality, nor of the economic cycle. The Great Moderation, wasn't, in other words.

Stocks have kept going up, in part, because leverage is cheap. Whether directly by companies borrowing to buy back shares, or indirectly via Private Equity LBO & corporate Merger & Acquisition activity, companies have been retiring equity. Stocks may be expensive, but it's very much in the interests of senior execs, who are incentivized by share price, to keep pushing share prices up.

I feel that at some point we might hit a "Minsky Moment" (or at least a "Wil-e-coyote moment") when this will start to unravel. All that extra debt will prove to have painful consequences for corporates.

China, I think, is more or less at that point. There are a number of weak points in the global economy and financial system-- such as US car loans, etc. But China is the one of the magnitude that it could really hit us all.

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Re: Larry Swedroe: This Metric In Dire Need Of Context

Postby aristotelian » Sun Jul 16, 2017 1:46 pm

To say that CAPE10 needs context is not to say that it is irrelevant. I don't know, with all respect to Swedroe, from whom I have learned a lot about investing, this article read as a list of justifications for ignoring valuation.

"The US has become wealthier"...By what evidence? Don't all modern economies get wealthier over time? What makes this period different that wealth translates to higher valuations relative to earnings?

"Accounting rules have changed"...That does not exactly put my mind at ease.

"CAPE10 is OK because of lower dividends"...I thought dividends are irrelevant to total return. They are irrelevant to price and to earnings, which are the two variables in P/E.

"The good news is international valuations are lower"...Thereby contradicting the above reasons for ignoring valuation.

Then, like a good guru, he then contradicts the entire piece and says valuation is probably important, so whatever happens with the market, he can say he was right.

I think the bigger factor than any of the above would be historically low interest rates propping up the market. That makes sense to me and gives me some hope that current valuations might be sustainable. Of course, interest rates are starting to normalize, so this effect may be running its course. Still, I would not jump to the conclusion that CAPE is irrelevant or that all of a sudden we are in a magic period where valuations can go to infinity without ever coming down to earth. I am not pulling out of the market immediately, but the more pieces like these I see in the popular press, the more I will be convinced we are approaching bubble territory.

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Re: Larry Swedroe: This Metric In Dire Need Of Context

Postby nedsaid » Sun Jul 16, 2017 4:06 pm

Wow! I seem to have hit a nerve here. What I am saying is that I would not use the Shiller P/E 10 as a sell signal for the market. I see it more as a warning about US valuations.

Valuethinker said:
The Shiller PE 10 flashed a huge warning sign in the late 1990s when the first edition of Irrational Exuberance came out. Duly, since then, equity markets have performed poorly.


Your statement above implied very strongly that the Shiller PE 10 was a good timing signal. "Flashed a huge warning sign" reminds me of the language of market timers as did the word "Duly." I don't believe that you are a market timer yourself, but you sounded like one. Like me, you are probably looking for cheaper asset classes and making or thinking of making shifts in your asset allocation based on this information. This phrasing is what triggered my comments.

As far as Bob Brinker and Elaine Garzarelli, they had their own timing systems. Brinker had something like four main things that he looked at and Garzarelli had something like 27 indicators. They had a rational approach for looking at the market and attempting to time it. As history has shown, their efforts were not successful. The P/E 10 is just one metric and it seems odd why one metric would work where 4 metrics and 27 metrics failed. P/E ratio is the most important metric that I look at but it isn't the only metric.

Have I ever said that P/E 10 was irrelevant? For the record, I think the Hindenburg omen is snake oil, which is why I have had fun with it. The P/E 10 is a useful metric but I wouldn't build a whole market timing system around it. Again, this metric gives us an idea of the valuation of the market.

I am in agreement that valuations matter and matter a lot. I am also in agreement that valuations give a good clue about expected future returns. I am also in agreement that future returns from the US Stock and Bond Markets are likely to be muted, certainly below historical norms. That is, unless we keep getting P/E expansion, and I am dubious about that.

I do resent the straw man characterization of my arguments. I had some fun with the P/E 10 metric because I have seen little discussion of it other than here and in Larry Swedroe's articles. The metric itself is not all that old. It seems that Shiller started in maybe in the late 1980's or early 1990's. The idea isn't new as Benjamin Graham sought a way of smoothing out volatile earnings, he thought that a P/E ratio smoothed out over longer time periods would be more useful than a snapshot at any given time. It is that I just puzzle over people declaring infallibility over a relatively new metric. The Dow Theory has been around for a very long time in comparison.

The thing is, if the US Market is horribly overvalued, why are other metrics like dividend yield and price to book near historical averages? Price to book surprises me since in my opinion book value as a metric is more important for some industries than for others. In other words, a lot of the value of companies now is intangible, such things as property, plant, and equipment are less and less of a company's true value. The book value of Microsoft is $9 a share and it trades at over $70 a share. The accountants really can't value the intangible value of the Microsoft Office franchise, or the Windows franchise, or the value of its intellectual property. In light of this, I would expect price to book ratios to be increasing and they have not. Again, dividend yield for the S&P 500 and the Total Market are about the same.

I do agree that a replacement value to price ratio would be a better measurement than book value but it just shows the limitations of accounting. The thing is, calculating replacement value for a company's assets is educated guesswork whereas book value is based on historical data. So nothing is perfect.

As far as GAAP, I am aware that there is greater movement towards more standardized accounting standards across the world. I would expect differences, though not wild differences, between accounting standards of the first world industrialized countries. Of course, the very large companies are almost all multi-nationals and I am sure they have figured out whatever differences there are in accounting standards. I would be very surprised if GAAP is wildly different from accounting standards in the UK or Western Europe. The thing is, the big accounting firms are multi-national as well.

The discussion of leverage is an interesting one. People forget that the equity part of the balance sheet is not cost free. Equity returns here in the United States have historically been 9% to 10% and so investors have those expectations of market returns. Cost of capital for the equity side isn't just 2%, which is pretty much the dividend yield of the US Market, but actually 9% to 10%. So if you can lever up a balance sheet a bit and borrow at let's say 3%, a good argument that a more levered balance sheet has a lower cost of capital than a balance sheet that is 100% equity, no debt. Borrowing money to buy shares makes even more sense if the dividend yield on the stock exceeds the yield of the bonds issued to retire the stock! A more levered balance sheet, the argument goes, could reduce both cost of capital and increase cash flow at the same time!

My point above is similar to occupancy costs. Corporations calculate internal occupancy costs even if they own the real estate outright. Sometimes a company finds the numbers work better if the company sells its real estate and then leases it back. Occupancy costs are there whether the company owns its own real estate or leases it. There is an expected return on capital even for its owned real estate. So I use this as an analogy to the cost of capital argument I make above.

Yes, I am aware that other factors are at work in US business other than lay-offs. I am aware of the anti-trust issues, and corporate executives managing companies for shareholder value. Your point about MBA's is also well taken. I have made a similar point of running your company by whatever your trade magazine tells you to do. Of course there are many factors involved in record profit margins of US Companies. I am also aware of capital vs. labor. Again, points well taken.
Last edited by nedsaid on Sun Jul 16, 2017 5:01 pm, edited 1 time in total.
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nedsaid
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Re: Larry Swedroe: This Metric In Dire Need Of Context

Postby nedsaid » Sun Jul 16, 2017 4:38 pm

Another point is that bull markets always make stocks look expensive. That this happens should not be a surprise as markets look towards the future and looks at things that individual investors might not. Earnings historically catch up with what seem to be inflated markets. Of course it is not a straight line upwards, we have bear markets in between. I always think of the Warren Buffett quote when asked if the market was expensive. "Yes," he said,"but not as expensive as it looks." Buffett is also relatively sanguine about market valuations and indeed is looking for deals right now and not just sitting on his big wad of cash. That should tell you something.

It is not that I am dismissive of arguments about valuations but quite honestly I can't tell you how many articles I have read that warned of an impending stock market crash or the next Great Depression. If I had believed all that stuff, I never would have invested. Historically, investors have been better served by optimism than pessimism. If nothing else, optimism opens the mind to see opportunity. A pessimist only sees problems, and well, there are always problems.

What I will say is that if market valuations make you nervous, it might be a good opportunity to rebalance the portfolio. There is also nothing inherently immoral about taking some profits off the top.

There are different opinions about markets, and indeed different opinions about securities within those markets. Different opinions make markets and lead to price discovery and more efficient markets.
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Re: Larry Swedroe: This Metric In Dire Need Of Context

Postby Top99% » Mon Jul 17, 2017 11:26 am

Thanks for sharing another interesting article from Larry. To me this one carried at least a faint whiff of "this time is different". Maybe this time really is different but I wouldn't bet my financial future on it. I guess I hedge my bets between the future resembling the past and being different than the past because both are likely to be true to some degree. Certainly we haven't had the same starting conditions in the US of: low bond yield + high stock valuations + less investing friction + companies focusing more on buying back shares Vs dividends in the past. And starting conditions always do matter.
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Re: Larry Swedroe: This Metric In Dire Need Of Context

Postby Da5id » Mon Jul 17, 2017 12:04 pm

Top99% wrote:Thanks for sharing another interesting article from Larry. To me this one carried at least a faint whiff of "this time is different". Maybe this time really is different but I wouldn't bet my financial future on it.


Got to say, I feel the same about the "this time is different" part. The reasons in the article all seem to me to make lots of sense. But well stated reasons always do seem to make sense, except in hindsight. Heck, maybe stocks have reached "a permanently high plateau".

I agree with those who say not to use CAPE10 for market timing regardless. If CAPE10 is still applicable, it only serves to make one more pessimistic about the range/average of expected future returns. Being quite conservative about my expectations for stock returns (could retire now at age 51 at 2.5% initial withdrawal rate, likely to retire next year regardless), I'm kind of a pessimist about stock market returns by nature anyway, preferring to be favorably surprised rather than disappointed.

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Re: Larry Swedroe: This Metric In Dire Need Of Context

Postby nedsaid » Mon Jul 17, 2017 12:08 pm

I really don't have anything against Shiller P/E 10. It is one metric out of many and not a bad metric at that. What I am reacting to is that this is a relatively recent metric. I am also reacting to the belief that this is an infallible indicator. It did not come down from Mt. Sinai with the 10 commandments. It didn't even come across the Atlantic on the Mayflower. It is almost like people are saying that P/E 10 hasn't been this high since tulipmania.
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