A version of this post was originally published on TKer.co.
Let's talk about the CAPE ratio. It is one of the most widely-followed stock market valuation and investing metrics. It's being talked about more as investors wonder whether stocks are poised to lose ground in 2022. The signal of doom it supposedly sends is a myth.
Robert Shiller, a Nobel Prize-winning economist, popularized CAPE, or cyclically adjusted price-earnings. It is calculated by taking the price of the S&P 500 and dividing it by the average of 10 years worth of earnings. The stock market is thought to be expensive when CAPE is above its long-term average.
Many market watchers use above-average CAPE readings as a signal that stocks should underperform or even fall as it returns to its long-term mean.
The meaning of CAPE doesn't actually have much pull.
In a new note to clients, Goldman Sachs wrote that valuations are a means-reversal and that we should dispel an oft-repeated myth that equity valuations are mean-reversing.
The analysts started their discussion by noting that the problematic assumption exists for metrics like CAPE to revert to.
Mean reversion assumes that market valuation metrics are stationary and their long-term means do not change, they wrote.
The valuation metrics have been high in the past and forced long-term means to move higher. Not long ago, GMO s Jeremy Grantham made a observation to argue that valuations were in a new normal at elevated levels.
We have not found any statistical evidence of mean-reversion at any rate. The case for mean-reversion is weak.
The Goldman Sachs analysts wrote that there was no statistical evidence of mean reversion. Equity valuations are a bounded time series with an upper bound because valuations can't reach infinity, and there is a lower bound because valuations can't go below zero. However, having upper and lower bounds doesn't mean valuations are stationary and revert to the same long-term mean. The Goldman analysts did the math, and the key metric to look at in the chart below is the statistical significance.
The statistical significance of the full sample is 26%. This means that there is only 26% confidence that the Shiller CAPE is mean-reversing, and 74% confidence that it is not. The traditional threshold to consider a relationship statistically significant is 95%. The Goldman analysts, however, didn't stop busting the myth and took issue with the concept of the CAPE ratio in general.
Even if we ignore this threshold, the time between valuations crossing into their 10th decile and returning to their long-term average is beyond a reasonable investment horizon for a tactical decision, they said. For example, in August 1989, the Shiller CAPE entered its 10th decile, but did not revert to its long-term mean for 13 years. In other words, trading based on the assumption that CAPE will mean-revert could lead to indeterminate years of getting smoked by the market.
The Goldman analysts addressed this myth in their reports published in 2013, 2014, 2018, and 2019.
They noted that this isn't just a CAPE-specific issue, but an issue with many valuation metrics, including valuation metrics applied to non-US stock markets.
I have flagged this problem recently here and here. For years, prominent people have been commenting on CAPE issues, including veteran Wall Street strategist Sean Darby, finance professor Jeremy Siegel, legendary investors Warren Buffett and blogger extraordinaire Michael Batnick.
Shiller himself warned about the reliability of CAPE.
A simple Google search for CAPE ratio will return years of articles about how the market is about to crash. It is being talked about now as stocks have had a bumpy ride to start the year.
The Goldman analysts wrote that valuations alone are not sufficient measures for underweighting equities. The time period for valuations to reach a long-term average is highly variable and therefore uncertain. Valuation metrics like CAPE and forward P E aren't worthless. They are a simple way of estimating the premium an investor pays for a company's earnings.
They just don't do a good job of telling you what stock prices will do in the coming days, months, or even years.
A version of this post was originally published on TKer.co.
Sam Ro is the author of TKer.co.