price-earnings (CAPE) ratio

How dare anyone challenge the sanctity of the cyclically-adjusted price-earnings (CAPE) ratio, arguably the most respected measure of stock market value.

CAPE has a very well documented track record of predicting long-term returns.

But we can't just ignore what the critics are saying about some of the model's inputs, especially as accounting standards change.

CAPE

Nobel prize-winning economist Robert Shiller popularized CAPE in his 2000 book "Irrational Exuberance," which effectively predicted the dotcom bubble when no one else would.

CAPE is calculated by taking the S&P 500 and dividing it by the average of ten years worth of earnings. If the ratio is above the long-term average of around 16x, the stock market is considered expensive

Currently, CAPE is at 25. The more bearish stock market experts point to this high CAPE as a precursor to an era of subpar stock market returns.

CAPE Critics

But CAPE has attracted its fair share of critics lately. Generally speaking, the critics argue that the earnings component of CAPE is just too low. Jeremy Siegel has argued new accounting standards have put a downward bias on earnings. Others like Jefferies' Sean Darby pointed out that the 10-year average of earnings is being unfairly penalized by a rare stretch of deflated earnings levels of the financial crisis.

UBS

In a note to clients on Monday, Societe Generale's Andrew Lapthorne took issue with net income, the earnings component referenced in Shiller's CAPE ratio.

Lapthorne argues that the year-over-year growth rate in net income in 2013 was actually inflated by the fact that there were a number of large, multi-billion dollar write-downs in 2012.

Write-downs were enormous impediments to net income during the crisis(see chart).

Because nonrecurring items like write-downs aren't reflective of ongoing operations, analysts often pay closer attention to earnings adjusted for these items.

Futhermore, evolving accounting standards have changed how write-downs are handled during merger and acquisition transactions. Shiller's CAPE does not account for this sufficiently.

Shiller's CAPE is beautiful in its simplicity and proven by its long track record. But this doesn't mean it can't be improved.

CAPE Alternative

Back in November, Deutsche Bank's David Bianco offered an adjusted CAPE measure. Among other things he made a tweak to account for changing accounting standards and noisy items that aren't adjusted for in Shiller's GAAP net income measure. From Bianco:

Shiller method uses GAAP EPS for the entire time series. We use GAAP EPS from 1900 to 1976, S&P Operating EPS from 1977-88 and IBES pro-forma EPS from 1989 onwards. SEC was not created until the Securities Exchange Act of 1934 and it took decades for US GAAP to develop and many changes have been made to the accounting standards. Since 2000 goodwill and asset write-downs increased owing to the elimination of pooling accounting for mergers and there are now regular impairment tests of acquired goodwill. This causes GAAP EPS to understate true EPS as high value assets are never written up.

Bianco also overhauled the way Shiller addressed inflation:

Historical EPS used in the Shiller method are inflation adjusted. As we argue earlier, adjusting only inflation does not account for the substantial changes in dividend payout ratio. The Bianco PE is based on equity time value adjusted (ETVA) EPS. We raise past period EPS by a nominal cost of equity estimate less the dividend yield for that period.

Bianco also took issue with the folks relying on 100+ year average for a baseline CAPE:

The current Shiller PE is usually compared to its 100+yrs average of 16.3x. This includes the WWI EPS cycle, when companies benefitted tremendously from supplying Europe. Profits tripled from 1914 to 1916, and then fell to less than a fifth during the 1921 post war recession. This exceptional profit swing distorts the long-term average 10yr PE a full point.

We advise comparing the current PE to its average from 1960 onwards as the S&P 500 didn't exist until 1957. From 1926-56 S&P Index data is based on the S&P 90 composite which comprised of 50 Industrial, 20 Railroad and 20 Utility stocks. Prior to 1926 the data is based on Cowles Commission Index data.

Considering all this, where does this put Bianco's CAPE?

Bianco's CAPE is 17.0 now. The Shiller PE is 24.9. The 1960-2013 average for these PEs are 15.6 and 19.6, respectively.

"Shiller PE suggests that S&P is overvalued, Bianco PE is reasonable," wrote Bianco in hist February 28 update.

Deutsche Bank

Updated February 28.

It's worth noting that Bianco is no raging bull. With a 1,850 target on the S&P 500, he's arguably the most bearish strategist on Wall Street. So he's not tweaking Shiller's CAPE just to support some bullish thesis.

What Would Robert Shiller Say About This?

How dare anyone challenge Shiller's CAPE?

This is the question posed by the folks who mostly have a "If it ain't broke, don't fix it attitude."

Bianco's alternative probably isn't perfect either. But the purpose of this exercise is to recognize that Shiller's CAPE is not without its problems.

In an April 2012 interview with Money Magazine, Shiller himself said something interesting about his CAPE.

"Things can go for 200 years and then change," he warned. "I even worry about the 10-year P/E - even that relationship could break down."

Though he does not address the accounting issues directly, his warning about his model's infallibility is pretty clear.

Cheat Sheet on Inequality

Every economy in the world looks upto US econ , we talk about the inequality today , In our country we have all kinds of inequality - income, caste, region , sex, color , sex preference , wealth and many more. 

This post highlights or rather compares America today with rest of the world in every era we can.

Talk about inequality has been in the news recently, but you won’t believe what’s really happening in America today:

• Inequality in America today is twice as bad as in ancient Rome, worse than it was in Tsarist Russia, Gilded Age America, modern Egypt, Tunisia or Yemen, many banana republics in Latin America, and worse than experienced by slaves in 1774 colonial America

• It’s the highest level of inequality ever recorded in the U.S.

• It’s worse in America than in any other developed nation

• Staggering inequality in America has become permanent

• There are 2 economies: one for the rich, and the other for everyone else

• The economy has only recovered for the 1% … the rest of the country is more or less stuck in a depression

• The super-rich are raking in more than ever

• On the other end, more and more people are sliding into poverty

• 1 out of every 5 households in the United States is on food stamps

• The middle class has more or less been destroyed

• A who’s who of prominent economists and investors say that inequality causes crashes and hurts the economy

• Extreme inequality helped cause the Great Depression, the current financial crisis … and the fall of the Roman Empire

• Inequality isn’t happening for mysterious or uncontrollable reasons. Bad government policy is responsible for runaway inequality

• Bush was horrible, but income inequality has increased even more under Obama than under Bush

• Americans consistently underestimate the amount of inequality in our country.  They will be shocked – and may be furious – when they learn the truth

• It’s a myth that conservatives accept runaway inequality.  Conservatives are as concerned as liberals regarding the stunning collapse of upward mobility

wise at 60

Death is not distant, it’s inevitable, and ever-closer.

No one knows anything. Confidence is a front. Everybody is insecure.

No one cares about your SAT scores unless they aced the test.

We’re all lonely looking to be connected.

You’ll regret choices earlier in your life, but you’ll accept them.

You’ll want the decade back when you were lost and drifting.

You’re never going to recover from some physical ills, aches and pains are part of the process of dying, and that’s what you’re doing, every day.

Women inject their lips to look good to other women, the same way they buy and wear trendy outfits and shoes. Men just want someone who will listen to them, soothe them and have sex with them.

Your parents said television was the idiot box, and you feel guilty every time you watch for hours, but you’re addicted.

Being good-looking is overrated. Sure, it opens some doors, but it stunts you in other ways. Character is built by challenges, if you avoid them, you’re at a loss.

Having friends is better than having money.

If you were never on the path to riches, you will never be rich.

Doors are closing every day. If there’s something you want to do, start now.

Acceptance is no easier than it was when you were five, but it’s necessary in order to soldier on.

You really want to be involved with someone your own age, because no matter how attractive a younger person might be, they do not get the references.

If a couple says they have no arguments, their divorce is imminent. Or one member lives in quiet desperation, fearful of stating their truth.

People let you down.

Everybody is out for themselves. They make decisions accordingly. Don’t take it personally.

Some people were dead at thirty. It’s a full time job trying to stay alive.

Most of what you learned in school you’ve already forgotten.

You lament they didn’t have calculators in school when you were forced to use a slide rule.

Where you went to college doesn’t matter, unless it was Harvard or Yale, because those are clubs whose members open doors for each other.

If you’re working for the man, it’s just a matter of time before you lose your job.

You probably won’t make as much money as your parents.

You probably drive a worse car every time you get a new one. Once upon a time you could afford a Volvo, now you drive a Camry.

People are dying to tell you their story. Ask them questions. They’ll tell you everything.

You’ll become more comfortable in your own skin.

You’ll be happier.

You’ll stop doing things you don’t want to do. Actually, this happens not long after you move out of your parents’ house.

You’ll stop being fascinated by that which consumed you previously. Sports may become meaningless.

You won’t know who the people they’re talking about in “People” and the rest of the gossip rags are, and you won’t care.

You’ll realize no one leaves their mark, except for a few people who didn’t know they were doing so, so it’s a futile pursuit.

Wrinkles only bother those who have them. Beauty changes when we get older. We’re looking for a glint in the eye, a sense of satisfaction and adventure.

If you’re up for anything, we’re attracted to you.

No one can keep a secret.

There are truly rich people and chances are you’re not one of them. Unless you’ve got a friend, you’ll rarely get the best seat, you’ll rarely get preferential treatment. You don’t want to see yourself as one of the unwashed masses, but you are.

You don’t want to be President.

Life is topsy-turvy, just because someone’s successful today, that does not mean they will be so tomorrow.

Even the best and the brightest have kids who screw up.

Not everybody has to go to college to be successful, although this is impossible for parents to accept when their children drop out.

People oftentimes don’t want to hear the truth, you’ll have trouble getting ahead if you don’t know when to hold your tongue.

Everybody gets cancer, if you ain’t got it, your time is coming.

You think you want to live forever, but you don’t, because none of your friends will be around to share it with.

There are two types of people, those who want to retire and those who don’t.

There are two types of people, those who prepared for retirement and those who didn’t, and some have to continue to work when they don’t want to.

Your health may not allow you to continue to work, even if you want to.

It’s fun learning what the people you grew up with are up to, but you really don’t want to hang with any of them that you weren’t hanging with before the Internet.

People don’t change. Certainly not unless they want to. So expect the person who bugged you in school to still bug you as an adult. And know that chances are you can never ever get back together with your ex because what caused the breakup back then still exists.

Marriage is hard.

Divorce is even harder.

Sometimes life is better with a new partner, but sometimes it’s not.

People who want to make you feel inadequate feel inadequate themselves.

Not everybody grows up, some are still bullies.

People who would hit you as kids won’t hit you as an adult, mostly because they’re afraid of the lawsuit.

The biggest rebel in school is complacent as an adult.

Some of your best friends will become Republicans.

Some of your best friends will retreat to religion.

You’ll laugh at those trying to look younger, or follow their lead down the path of inadequacy.

You’ll regret you stopped piano lessons.

You’ll see the passing of your parents as a precursor to your own demise. Once they’re gone, you’re next.

You’ll love making references to old movies and songs.

Unless you have children, the Top Forty will become meaningless.

You’ll be stunned that the biggest TV shows and stars of yore will become forgotten as time goes by.

You’ll be more interested in the news, and more interested in politics.

You’ll think it was better when you were young.

Even though you are closer to death, you won’t want to be young again. You had so many questions, you were so angst-ridden, you were searching. As the cliche goes, youth is wasted on the young.

The key to longevity is letting go of the past.

You’ll look back at one specific time in your life when you were happiest, and you’ll discover the people who shared the experience agree with you.

You’ll hear from all your significant others, looking for…what they’re not sure.

You’ll recognize hype for what it is. And become disillusioned by it and advertising.

You’ll realize every generation has a teen phenom, a boy band that captures girls’ hearts that fades away.

Stars who can’t go out in public during their heyday will be at the mall buying keys and no one will pay attention to them.

Being famous is overrated, you treasure your anonymity.

Life is for the living, so live it up!