The forgotten ratio? Sticking with CAPE

No, I’m not a permabear. I actually would desperately like to be fully invested, maybe even with a modest amount of leverage. It just hasn’t been possible at price levels that make since for several years now and the falls that occurred between late February and March 23 didn’t quite get us there.

You see, I have a dirty secret. Please don’t tell anyone- but I still believe in CAPE. Oh god, so now you know. The ratio that has become a laughing stock and claims the market has been wickedly overvalued the last several years. I actually think the CAPE underestimates the overvaluation of the US market, because it doesn’t fully account for historically high profit margins over the last decade, but let’s not even go there.

Robert Shiller’s measure was lauded around the dotcom boom as it peaked perfectly and historically with the largest stock bubble of modern finance, reaching a high of 40x in early 2000 only to drop away sharply as the MMT bubble popped.

The only trouble was, it didn’t drop away into the single digits, as it had in the other truly epic busts of the 20th century. It didn’t even get to its long run mean of around 16x. In fact the only time it would go on to return to its long run mean was March 2008 at the depths of the GFC, before powering away again.

After the longest bull run in history, the S&P 500 entered the 2020 on a CAPE of 33x- not quite the dotcom blowoff, but clearly the second most expensive market in history. Derision of the CAPE ratio was being sung from the rooftops and the obituary was being written. The arguments included that the CAPE actually undervalued the market because it included the GFC trough (they’ve just rolled out), that it has been “wrong” for a decade and that the ratio doesn’t account for stock buybacks.

I think these arguments are spurious and miss the forest for the trees. For one thing- it’s supposed to represent a full cycle. Having recession earnings in there is the whole point.

As for the ratio being “wrong” for a decade, it’s not a timing tool. It is intended to be a sober look at where valuations stand from a long term investors viewpoint and can hold place with Buffet’s Market Cap/GDP and Tobin’s Q in this regard. The fact that it has gotten to extreme levels is a result of the price being fed in- CAPE is a normalised PE ratio after all. To get to bubble valuations, expensive levels need to get even more expensive for a period of time.

And even if you want to claim that stock buybacks have structurally altered the CAPE, do you consider the current level of buybacks to be a permanently high plateau? Because I hate to tell you, but if and when we have a sustained bear market, those buybacks tend to go away. In fact, they tend to reverse into capital raisings and some of that equity will be reissued.

The one argument I can have some sympathy for is that with IT companies now making up more of the market than ever, isn’t it justified that the market would trade at a higher multiple? Cloud computing is, after all, much more asset light and higher ROE than running a railroad or American Can.

Well maybe, but the question is by how much? And are these changes permanent? In investing, John Templeton’s immortal statement about “this time it’s different” being the most dangerous words in finance are best heeded and only stepped over lightly.

Research Affiliates have done some insightful research into what they call the global “Top Dogs”. Basically, the largest 10 companies by global market cap have underperformed in nearly every decade after reaching Top Dog status. And the list looks quite different from one decade to the next. A historically informed base rate simply needs to allow that the 2030 list won’t contain most of FAANGM.

This doesn’t preclude them continuing as successful enterprises. It just means that a period in the wilderness growing into their valuations is likely. This is not a terribly bold statement. Merely a historically informed expectation. A similar phenomenon played out in Amazon and Cisco after 2000.

It is a very brave call to say that something that has worked fairly well for over a century is no longer applicable. I think any tinkering needs to be done around the edges and incrementally.

The storied Boston firm GMO has luckily done some work around mean reversion of the CAPE and have even been running a second set of return forecasts lately. These assume that the CAPE will only revert 66% of the way to its long term mean and do this over a longer time frame.

Unfortunately the returns to US stocks would still be horrendous under this second outcome and this is where I talk about missing the forest from the trees. I could understand if we are sitting on a CAPE of 20x arguing about whether the long term mean should be revised upwards. But when you’re sitting atop the second most expensive valuations of all time, it is simply myopic to claim that fair value conveniently matches your current circumstances.

Sure- fair value is whatever you want it to be. But I’ll keep my faith in the price you pay being the main determinant of your return.

So, what happened in March? The market fell from around 33x to around 22x before bouncing back to 27x today. Yes, I wish I’d done more buying around March 23, hindsight is always 20/20. But the fact is a CAPE of 22x is not exactly the sort of levels fortunes are built on.

I nibbled a little, I entered a position in Aimia and added to MicroFocus and Liberty Latin America, but I couldn’t bring myself to fire the bazooka and get fully invested. At the 23rd of March, the S&P500 was at levels it first crossed in April 2017. Do you remember the bear market lows of 2017? Me neither, it was 3/4 of the way through the longest bull run in history.

So how low can the CAPE get and what level would I get excited at? The first is easy to answer by looking at the historic chart. In 1932 the CAPE bottomed at 6x and in 1982 stalled out at 7x, both of which were fabulous times to invest. In fact after the 1982 lows, the S&P 500 would rise 15-fold over the next 18 years.

As to what I levels I would want to get fully invested. Am I holding out for 1982 levels? Of course not. Howard Marks put it well in a recent memo where he said that our goal as investors is to make “a large number of good buys, not a few perfect ones”.

I am in my early/mid thirties, so I have time on my side. I’m looking to get fully invested at prices that are reasonable, not wait for once in a century opportunities that may never materialise. I just don’t think the CAPE approaching it’s hundred year mean is asking too much. Even if you treat 20x as a new era mean, bear markets have a history of overshooting on the downside. A long term buyer only needs it to get there long enough to summon their nerve and roll up their sleeves.

Of course as an active investor, there will always be interesting stocks that have fallen a lot further than the market under such a scenario and I will be looking to these, as I am now.

Am I saying that this is a guaranteed bear market bounce and we are about to fall to new lows? No, I certainly think it’s possible, but I really have no idea. But if it doesn’t happen this time, there will come a time when the market becomes truly cheap again and I’ll be waiting… looking slightly haggard perhaps.

Next post I’ll look around the globe to where valuations are looking more attractive and challenge the idea of American exceptionalism (at least in stock valuation) a little more.

Guy