Are Grantham and Hussman Correct About Valuations?

Five faults behind the CAPE ratio

While the Shiller CAPE 10’s historical mean is about 16.5, the data set for the full period going back to the 1870s includes distinct economic eras in which the world looked very different.

Consider just two examples. For a significant part of the data set’s full period, there was neither a Federal Reserve to help dampen economic volatility nor an SEC to protect investor interests. The presence of both organizations has made the world a safer place for investors, justifying a lower equity risk premium, and thus higher valuations. In addition, we haven’t experienced another Great Depression, and there haven’t been any world wars since 1945.

With that in mind, if we consider only the period from 1960 through May 2015, the Shiller CAPE 10’s historical mean is 19.7. If we begin in 1970, the figure is very similar at 19.5. And it increases to 21.4 if we begin in 1980.

The fall in the equity risk premium demanded by investors, which can be seen in the rising mean of the Shiller CAPE 10, is quite logical. Beyond the reasons mentioned above and everything else being equal, the wealthier a nation, the lower the risk premium an investor should expect.

Consider three countries: the U.S. (a developed country), Brazil (an emerging country) and Kazakhstan (a frontier country). Which of these should have the highest cost of capital and thus the highest expected return to the providers of that capital (investors)?

The answer should be Kazakhstan because in frontier markets capital is a very scarce resource. Economic theory tells us that the scarce resource should earn the higher “economic rent.” Moreover, frontier market countries typically have weaker regulatory environments when it comes to investor protection. And it’s often the case that foreign investors have even less protection than domestic ones.

As a result, the cost of capital in such markets is very high. In turn, valuations are low and expected returns are high. As those countries progress over time from frontier to emerging to developed markets, the cost of capital tends to fall as capital becomes less scarce and the regulatory environment is strengthened.

So it shouldn’t be a surprise that the mean CAPE 10 ratio has migrated higher as the U.S. has become wealthier, regulatory regimes have become stronger and the Federal Reserve has benefited from prior experience.

The second reason why the Shiller CAPE 10’s full-period mean may be an inappropriate benchmark is because accounting rules have changed, impacting how earnings (and thus price-to-earnings, or P/E, ratios) are determined.

In 2001, the Financial Accounting Standards Board (FASB) changed the rules regarding how goodwill is written off. As the anonymous blogger Philosophic Economics explained: “In the old days, GAAP required goodwill amounts to be amortized -- deducted from earnings as an incremental non-cash expense – over a forty-year period. But in 2001, the standard changed. FAS 142 was introduced, which eliminated the amortization of goodwill entirely. Instead of amortizing the goodwill on their balance sheets over a multi-decade period, companies are now required to annually test it for impairment. In plain English, this means that they have to examine, on an annual basis, any corporate assets that they’ve acquired, and make sure that those assets are still reasonably worth the prices paid. If they conclude that the assets are not worth the prices paid, then they have to write down their goodwill. The requirement for annual impairment testing doesn’t just apply to goodwill, it applies to all intangible assets, and, per FAS 144 (issued a couple months later), all long-lived assets.”

While FAS 142 may be a more accurate method of accounting, it has created an inconsistency in earnings measurements. Present values end up looking more expensive relative to the past than they actually are. And the difference is quite dramatic. While the CAPE 10 ratio as currently measured is about 27.1, adjusting for the accounting change would put it about 4 points lower.

The third reason not to rely on the long-term historical mean of the CAPE 10 is that far fewer companies pay dividends now than in the past. For example, in their 2000 study, “Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?”, Eugene Fama and Kenneth French found that the firms paying cash dividends fell from 67% in 1978 to 21% in 1999. In the United States, this has resulted in the dividend payout ratio on the S&P 500 falling from an average of 52% from 1954 through 1995 to just 34% from 1995 through 2013.

In theory, higher retention of earnings should result in faster growth of earnings as firms reinvest that retained capital. That has been the case for this particular period; from 1954 to 1995 the growth rate in real earnings per share (EPS) averaged 1.72% and from 1995 to 2013 it averaged 4.9%. With S&P 500 earnings in 2014 of $114.74 and dividends of $38.57, the payout ratio was down to 33.6%.

Philosophical Economics explained that in order to make comparisons between present and past values of the Shiller CAPE 10, differences in payout ratios must be normalized. The adjustment between a 52% payout ratio (the average from 1954 through 1995) and a 34% payout ratio (the average since 1995) corresponds to approximately a one-point difference on the Shiller CAPE 10.

But, we aren’t done making adjustments.

New York University finance professor Aswath Damodaran writes one of the two investment-related blogs I read on regular basis. (The other is authored by University of Chicago professor John Cochrane.) In a June post, Damodaran addressed the impact of debt and cash on valuations (P/E ratios).

Logically, and with all else being equal, more cash on a company’s balance sheet decreases the risks involved with owning that firm’s stocks, reducing the required equity premium. That, in turn, raises the P/E ratio. Alternatively, having more debt increases the risks of owning that company’s stocks, raises the required equity premium and lowers the P/E ratio.

After discussing the logic and presenting some pertinent examples, Damodaran concluded: “Like most investors, I like the simplicity and intuitive feel of [P/E] ratios, but they are blunt instruments that can get us into trouble, when used casually. A low [P/E] ratio can be indicative of cheapness, but it can also be the result of high debt ratios and low or no cash holdings. Conversely, a high [P/E] ratio can point to over priced stocks, but it can be caused by high cash balances and low debt ratios.” He offered the following suggestion: “When comparing [P/E] ratios across time, don’t ignore cash holdings and debt” because “shifts can affect the [P/E] ratios for the market, making it look expensive when cash balances are high and debt ratios are low.”

This raises the question: How do today’s cash and debt levels compare to historical averages? Damodaran provided the necessary information.

He wrote: “In 2014, the cash holdings at non-financial service companies in the U.S. amounted to 7.30%, higher than the median value of 7.23% for that statistic from 1962 to 2014, and the total debt was 24.20% of value, lower than the median value of 28.39 for that ratio from 1962 to 2014. Since cash pushes up [P/E] ratios and debt pushes down [P/E] ratios, the 2014 levels for both variables are biasing [P/E] ratios upwards, relative to history.”

While I believe my first four points paint a clear picture of why the Shiller CAPE 10 ratio’s full-period mean is an inappropriate benchmark, I am not done yet. The fifth, and final, reason involves the changes that have occurred over time to the liquidity and trading costs of stocks.

The cost of liquidity/trading

Investors demand a premium for taking liquidity risk (less-liquid investments tend to outperform more liquid investments). There’s a perfectly logical economic explanation for this phenomenon: All else being equal, investors prefer greater liquidity. Thus, they demand a risk premium to hold less-liquid assets.

Liquidity is a risk factor, just like beta. And over time the cost of liquidity, in the form of bid-offer spreads, has decreased. There are several reasons for this, including the decimalization of stock prices and the provision of additional liquidity by high-frequency traders.

Another important factor is that the presence of financial instruments that allow investors to buy and sell illiquid assets indirectly (such as index funds and ETFs) work to lower the sensitivity of returns to liquidity. These instruments enable investors to hold illiquid stocks indirectly with very low transaction costs, reducing the sensitivity of returns to liquidity. With these innovations in markets, all else equal, we should see a fall in the equity risk premium demanded by investors, and thus higher valuations.

Summary

I have examined five compelling reasons why using the long-term historical mean of the Shiller CAPE 10 is an inappropriate benchmark for valuations, or at least one that will lead you to draw the wrong conclusions and thus make a poor investment decision.

Over time, the equity risk premium demanded by U.S. investors has fallen. To address this issue and perhaps obtain a more accurate yardstick by which to evaluate the current CAPE 10, one could use the ratio’s mean from 1960, covering a span of 55 years. That raises the average CAPE 10 from 16.6 to 19.7.

If we then make adjustments in the CAPE 10 required to account for FAS 142 and the greater retention of earnings by firms, we are now at an “adjusted” mean CAPE 10 of 24.7. These calculations put the adjusted CAPE 10 level within 10% of the current level of approximately 27.

But there’s still one more factor for which we need to account.

While corporate cash balances are only slightly higher than the historical average, debt ratios are quite a bit lower (24.20% versus 28.39%). Some might add that the current level of real interest rates is well below the historical average and is likely to remain so for a while. That, too, could be creating a justified upward boost to the P/E ratio. At the very least, controlling for these two issues narrows the gap, if not eliminates it.

That begs two questions:

1. Are stocks really overvalued or just highly valued? In other words, is it possible that returns are likely to be lower than historical levels, but without there being any reason to expect a major correction due to reversion to the mean?

2. If you believe in mean reversion, to what mean should the CAPE 10 ratio revert? To the 16.5 mean of the full period, the 19.6 mean since 1960 or to the adjusted figure of 24.7 that would account for the change in FAS 142 and lower dividend payout rate? What about an adjustment for the lower levels of debt on corporate balance sheets? And what about accounting for the low risk-free rate?

There are several very plausible explanations why the current high level of the Shiller CAPE 10 does not signal overvaluation of U.S. stocks, let alone the massive overvaluation advanced by Grantham and many others.

Larry Swedroe is director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.

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