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The author of that post suggests that the CAPE is useless for comparisons since FAS 157 changed accounting for fair value. A review of other posts recently made by the author indicate that he is fairly bullish on not just the market, but also the economy.

I am a rational optimist and I would like to be as optimistic as “valueplays”, but he is wrong to assume that the reason for the concern about market valuation is merely because of the level of the CAPE. As I have written in more detail before, and even indicated in that last post, it is the other statistics that consistently corroborate the CAPE that indicate there is not something fundamentally different about this period compared with prior periods.

Consider, for example, Tobin’s Q ratio, which measures the market’s price relative to the replacement cost of the assets for all of the companies in the market. It is higher than at any time in history bar the dot com bubble when investor psyche went overboard on “it’s different this time” thinking.

Notice that Tobin’s Q is not a straight measure of corporate book value, for which it is possible that one component–retained earnings–could be distorted by FAS 157. Tobin’s Q is an estimate of the cost to replace the assets that are already in productive use. It may not be perfect, but it corroborates the implications of the CAPE.

Consider, also,  Warren Buffett’s favorite indicator of market valuation known as Buffett’s P/E given by the following ratio:

(Market capitalization) / (Nominal GDP)

Notice FAS 157 would have little influence on nominal GDP. Buffett’s P/E is more than two standard deviations higher than it’s average since 1950. Again, the only time it has been higher was during the ridiculous dot com bubble.

I have also written that the recovery has been weak based on my favorite employment statistic. But, earlier this month ”valueplays” saw “Positive Signs Everywhere“. I certainly hope he is correct, but this market looks to me like it is one misstep away from a long fall based on the above statistics and:

1. Total debt is higher than at any time in history (there was no de-leveraging);
2. Interest rates are lower and the Federal Reserve Balance Sheet is higher than any time in history. The Fed is practically out of bullets; and
3. Corporate profits–the most mean-reverting statistic in finance according to Jeremy Grantham at GMO–are as high as they have been in history;

Invest accordingly.

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We still have some way to go before asset prices normalize for the S&P 500 index, which makes up about 90% of US stock market capitalization. The CAPE and all price-to-fundamental ratios like it (e.g. Tobin’s Q, Buffett’s PE, etc.) are still high and they are all higher than their long-run averages by about the same percentage. That consistency reinforces the notion that it’s the market’s price that is the issue and not that there is something fundamentally different this time with respect to earnings, free cash flow or the replacement cost of business assets.

The CAPE is 24.90 after (last week’s) drop in the S&P 500 to 1970.89. Even if we generously assumed that real S&P earnings for the most recently available month (March 2015’s $100.57) was the proper figure to use in the denominator (as opposed to the lower real $79.13 S&P earnings over the last ten years), the S&P 500 index could still fall another 15% before the CAPE reached its long-term average (16.63). Unfortunately, no one knows when it will regress back to that level. It is impossible to predict it.

In addition, few consider that maybe the current CAPE average is too high. Both the numerator and denominator in the CAPE are adjusted for CPI inflation, so it reduces the ratio to long-run fundamental market and business activity. The CAPE averaged 14.78 from January 1881 through December 1994, which is 11% less than today’s CAPE average since 1881, largely because today’s CAPE average includes the greatest bubble in the market’s history (the dot com bubble). That suggests the S&P could fall 25% from 1970.89 even with the generous earnings figure used for the denominator.

PAR does not care about the market as a whole when it invests client funds in its Separate Account Value Investing (SAVI) strategies, so PAR is not investing as if the market were going to drop another 25%. PAR is still looking from the bottom up for SAVI  clients because that is the way to uncover opportunities that have an MOS, but there should be no surprise that there are far fewer opportunities when the CAPE is 24.9, like today, than when the CAPE is 13.3 as it was in March of 2009.

March 2009  was the last time PAR became fully invested. Most of those new positions in which PAR invested in 4Q08 and 1Q09 to become fully invested were gradually liquidated over the subsequent twelve- to eighteen-months and have largely sat in cash  since. PAR’s SAVI strategies are only a small part of PAR’s clients’ portfolios.

PAR Wealth Management also offers traditional wealth management services as a fee-only fiduciary. PAR Wealth Management is a goals-based financial adviser. Once a client’s goals are quantified and prioritized, PAR Wealth Management allocates that client’s capital to investments with qualities that match those specific goals and how a client feels about risk. Capital for short- and intermediate-term goals are generally allocated to safer, more-liquid investments. For a large percentage of a client’s long-term goal allocation, PAR Wealth Management generally chooses external managers who demonstrate an ability to capture factor premia.

Update 8-24-15: I do not want to leave the impression that the only way for the CAPE to normalize is for the S&P 500 to drop precipitously. The other way is for the denominator–earnings–to rise considerably. But, the denominator will not rise without growth in value-creating economic activity in the private sector, and that takes time. Value-creation has been stagnant since 2008 and there is little on the horizon to suggest that the private sector will turn robust. In any case, the numerator (the level of the S&P 500) would have to rise much slower than the denominator. So, either way, whether it is a numerator that falls or a denominator that rises or some combination, it portends low stock market returns over the next decade. As I have written before, invest accordingly.

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The first statistic is a macroeconomic indicator called the Employment-to-Population Ratio (E/Pop, to distinguish it from E/P or earnings yield). I prefer E/Pop to all other employment-health indicators because, unlike the unemployment and labor force participation rates, it takes the least amount of manipulation to calculate it.

E/Pop is simply the number of adults (16+ YO) employed in the US divided by the number of people 16+ living in the US who are not in institutions (jail, mental health facilities, etc.) or in the military. No one has to guess whether these people are “looking” for work or really “participating”. It measures the  number of people truly working relative to the number of us relying on those who are working to pay our collective bills. After all, the money that pays our bills can only come from people who produce; it is not created from thin air.

If there is a weakness in this indicator, it is that it overestimates economic strength by including in the numerator those who work part time, especially now when the proportion of part time workers is elevated.

http://www.advisorperspectives.com/dshort/updates/Full-Time-vs-Part-Time-Employment.php

Robust economic conditions are indicated by relatively high E/Pop ratios and weak conditions by relatively low E/Pop ratios.

The E/Pop has indicated that the economy is weak and that this “recovery” since 2007 could easily be labeled “stagnation”. The E/Pop plummeted in the housing crisis and despite unprecedented fiscal and monetary stimulus, it has barely gotten off the mat since. May’s reading announced today is 59.4%. The last time (before the current stagnation) that it was this low was in April 1984 when the economy was still digesting Paul Volcker’s attempt to choke off the inflation debacle of the late 1970s.

The second statistic–one that continues to worry me about the stock market–is Robert Shiller’s Cyclically Adjusted PE (CAPE) ratio. The latest reading shows that the stock market’s price equals 27.38 times its trailing ten-year earnings. The last time it was this high was July 2007, almost to the day that the housing crisis began and about one year before the stock market plummeted in response. It was higher only twice before in history, just before two of history’s most terrifying market crashes.

I write about these “macro” themes because, as Howard Marks says, it’s important for “intelligent investors” to know where the economy and market stand as they go about their business of evaluating businesses one-by-one and determining whether they can purchase those businesses at prices that deliver a Margin of Safety. Since 2011, the level of the CAPE helps explains why investors have found so few opportunities that possess a Margin of Safety. Invest appropriately.

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“Every day you’re not selling an asset that’s in your portfolio, you’re choosing to buy it.”

The idea is that managers have to look at everything fresh every day in light of all new information, so that holding a position is no different from buying it, especially if there are no tax implications for selling (e.g. positions in retirement accounts, endowments, etc.). That perspective helps prevent managers from falling in love with their positions. It’s akin to Sir Arthur Quiller-Couch’s admonition for writers to “Murder your darlings.”

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The S&P 500 Index delivered a 13.69% return in 2014 as the market continued to reach new highs after reaching new highs in 2013. This year, for the first time, I have highlighted the years corresponding with the inflation and bursting of the DotCom bubble (grey) in addition to the Great Depression (yellow) and the Housing bubble (blue).

Clearly, there were more extremes and more years of extreme results during the Great Depression than the two most recent crises. In eight of the years from 1928 through 1938, the market either lost or gained more than 30%. In contrast, in each of the DotCom and the Housing bubble periods, the market had just one year of such an extreme.

There were obviously more extremes and more years of extreme outcomes during the Great Depression than the two most recent crises. Over the eight years from 1928 to 1938, generic cialis sales grew by 40% and you can read more about these successes on the main page of our website.

In half of all years since 1825, the market delivered a return between -10% and +10%. So, if we narrow the definition of extreme to losses or gains of more than 10%, the Great Depression experienced nine such years, the DotCom bubble five, and the Housing bubble five.

Many argue that the Federal Reserve is getting better at managing crises, and the above data would seem to agree. The Great Depression was the first crisis that the Fed experienced and many recent policy makers, including Ben Bernanke, went to school on Great Depression policy. On the other hand, others argue that the mere awareness of a Federal Reserve “put” is creating crises that future Fed policy will be unable to fix. I guess we will know who is right soon enough.

The return mode is still 0% to 10%. In a large majority (71%) of years, the market is positive. And, the market experiences declines of 10% (20%) or more in a mere 13.7% (4.9%) of years. So, an outsider’s perspective indicates that investing in the broad market is clearly in your favor, in part because of natural inflationary increases, and in part because of real increases in productivity and earnings due to technological and human capital advances.

The insider’s perspective is a different story. As of January 19, 2015, Shiller’s CAPE sits at 26.7, which is 61% above the average CAPE of 16.6 since January, 1881. The only periods in which the CAPE was higher than today were 1929 – 1930, immediately before the Great Depression; late 1996 – 2002, immediately before and after the DotCom bubble burst; and from late 2004 – late 2007, immediately before the bursting of the housing bubble. So, the CAPE is not a great short-term timing mechanism because recent extremes were able to persist for long periods, but it is an excellent indicator that the piper has to be paid eventually.

Other market indicators including Tobin’s Q and Buffett’s PE confirm the implications of Shiller’s CAPE. Investors who were cautious in periods like this had dry powder to exploit market declines. Investors who chased returns in periods like this rode the market without a brake (a hedge) and often only got off the ride by jumping off at market lows.

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If it is easy for corporations to borrow in public debt markets because high liquidity keeps interest rates low (in the near term), corporations that lack ideas for organic expansion at high ROI will issue debt and use the proceeds to buy back equity or go on M&A sprees. Those purchases raise the price of equities regardless of underlying fundamentals.

If it is easy to borrow from a bank or in public debt markets to buy a residence for occupancy or investment (see, e.g. Blackstone’s residential investment fund http://www.blackstone.com/businesses/aam/real-estate), consumers and investors will borrow and push up house prices. There is evidence from the structured finance industry that the market that has been least resistant to secondary financing has been the auto loan ABS market, especially in sub prime loans. It’s no surprise, then, that auto prices have held up better than home prices as borrowers find easier access to auto credit than mortgage loan credit.

http://www.standardandpoors.com/spf/swf/auto_abs/index.html#/54

Finally, the least resistant path for liquidity may be in the art world as wealthy investors need to “do something” with their cash that is earning next to nothing in the fixed income market. Doing nothing can be very difficult.

In the year from July 2013, sales of contemporary art at public auctions reached $2.046 billion dollars, up 40 percent on the previous year, Artprice’s annual report said.

http://news.yahoo.com/record-breaking-contemporary-art-103321463.html

Howard Marks has a great maxim for this behavior:

What the wise man does in the beginning, the fool does in the end.

We are in unchartered territory with respect to Quantitative Easing, but as Herb Stein has said, “If something cannot go on forever, it will stop.” The Fed will have to stop providing liquidity eventually. When the Fed stops, many will be caught by surprise and they will suffer. Don’t be one of those people.

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“There was one additional dissenter for the September statement. Philadelphia Fed President Charles Plosser voted against the position in July, and he was joined this month by Dallas Fed President Richard Fisher.

‘President Fisher believed that the continued strengthening of the real economy, improved outlook for labor utilization and for general price stability, and continued signs of financial market excess (my emphasis), will likely warrant an earlier reduction in monetary accommodation than is suggested by the Committee’s stated forward guidance,’ the statement said.”

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http://www.blackrockblog.com/2014/08/07/great-deleveraging-happened-debt-problem/

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I usually have a negative knee-jerk reaction to anyone who says “it’s different this time” and true to form, I disagree with Sufi’s argument that capital can replace labor completely. His is a Luddite argument that has been made since the industrial revolution and never materialized. Capital can only replace labor when (if?) we reach the Singularity and machines can reproduce themselves. (By machines, I mean both mechanical and electronic.) Until then, back-breaking labor will be replaced by machines that, in order to propagate, will need engineers and programmers and maintenance workers and chip makers, and entrepreneurs who can employ machines in purposeful activity, etc.  That reminds me; I also added Ray Kurzweil’s website to the blogroll.

http://blogs.cfainstitute.org/investor/2014/07/23/debt-and-secular-stagnation-amir-sufi-discusses-the-us-recovery-video/

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