Does Jeremy Siegel Trust the Shiller P/E?
In early August, Wharton finance professor Jeremy Siegel went on CNBC’s “Futures Now” and announced, “my target [for the DOW] is 16,000 to 17,000 for the end of this year…and I think 18,000 is definitely achievable in 2014.”
Siegel continued, “the market is totally spooked by whether QE continues or not,” but the Fed “would never accelerate tapering unless the economy was so much stronger, which has got to be good for earnings. So in one way, you can’t lose on stocks—either the economy’s weak, the tapering will end; or the economy’s strong, they’ll taper, and earnings will be strong. That’s why I think stocks are still a win-win situation.”
It’s pretty clear that Siegel is currently bullish, but predicting the stock market is an especially tricky proposition, so we took note when last Monday, August 19, Siegel took another swipe at the bears when he published an opinion piece in the Financial Times entitled “Don’t put faith in CAPE crusaders,” in which he argues that the high current Shiller P/E (also known as the cyclically adjusted P/E or “CAPE”) offers a distorted measure of stock market valuation due to a downward bias in earnings caused by accounting changes. As Siegel put it in the piece:
“The Cape ratio has been a powerful predictor of long-term equity returns, forecasting strong returns in the early 1980s and poor returns from the market peak in 2000. But for many years its predictions have been very bearish. In fact, in all but nine months in the past 22 years the Cape ratio has been above its long-term average, and the ratio currently predicts well below-average stock returns.
I believe the Cape ratio’s overly pessimistic predictions are based on biased earnings data. Changes in the accounting standards in the 1990s forced companies to charge large write-offs when assets they hold fall in price, but when assets rise in price they do not boost earnings unless the asset is sold. This change in earnings patterns is evident when comparing the cyclical behaviour of Standard and Poor’s earnings series with the after-tax profit series published in the National Income and Product Accounts (NIPA).
For the 2001-02 and 2007-09 recessions, S&P reported earnings dropped precipitously due to a few companies with huge write-offs, while NIPA earnings were more stable. Yet before 2000, the cyclical behaviour of the two series was similar. Downward biased S&P earnings send average 10-year earnings down and bias the Cape ratio upward. In fact, when NIPA profits are substituted for S&P reported earnings in the Cape model, the current market shows no overvaluation.”
Meb Faber over at Cambria Investments responded on his blog yesterday, arguing that even this “earnings bias” idea is true, and we add back the effect of those writedowns, the market is still expensive:
Last year, Cliff Asness, founder of AQR Capital Management, published a compelling white paper on CAPE entitled, “An Old Friend: The Stock Market’s Shiller P/E,” in which he had the following to say to those who would use historical accounting changes, or other “this time is different” –type arguments as a basis for objecting to the Shiller P/E:
“…some critics say you can’t compare today to the past because accounting standards have changed, and the long-term past contains things like World Wars and Depressions. While I don’t buy it, this argument applies equally to the one-year P/E which many are still somehow willing to use. Also it’s ironic that the chief argument of the critics…is that the last 10 years are just too disastrous to be meaningful…Does it seem to anyone else but me that the critics have a reason to exclude everything that might make one say stocks are expensive, and instead pick time periods for comparisons and methods of measurement that will always (adapting on the fly) say stocks are fair or cheap?”
So what do our readers think? Is it reasonable to argue that Siegel is simply saying “this time is different,” when he says the Shiller P/E is flawed at this particular point in time? We will be interested to see whether Siegel’s bullish projections are borne out.
If you are looking for some additional background, below are a few of our observations on the Shiller P/E and the subject of predicting stock market returns:
Note: This site provides NO information on our value investing ETFs or our momentum investing ETFs. Please refer to this site.
Join thousands of other readers and subscribe to our blog.
Please remember that past performance is not an indicator of future results. Please read our full disclosures. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. This material has been provided to you solely for information and educational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Alpha Architect to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Alpha Architect.
Definitions of common statistics used in our analysis are available here (towards the bottom)