A medium-term equity market warning

The American economist Robert Shiller is a Nobel laureate for several reasons.

One of them is the cyclically adjusted price earnings (Cape) ratio. Shiller’s device overcomes a serious defect in the more conventionally used price to earnings (PE) ratio which is often used to measure quickly whether a share is relatively expensive or cheap.The problem with the conventional PE ratio is that if earnings or profits are cyclically inflated, then even an inflated share price can be made to look reasonable. 

Shiller’s elegant answer to this problem was to discard annual earnings as the “E” or earnings figure and to replace it with a measure of cyclically adjusted earnings. In order to generate a measure of corporate earnings that reflected the whole cycle, rather than risk being deceived by using cyclical peak earnings, Shiller opted to use average earnings from the previous decade instead.

By comparing today’s share price to average earnings over the previous decade — rather than just the earnings of the past 12 months — the risk that one may be misled by a temporarily elevated level of earnings is significantly reduced.

The advantage of using Cape as a measure of value is that it provides a useful predictor of future equity returns, at least when one uses it to measure value across an entire national stock market.

The best returns from investing in the US stock market were made in the past after its Cape had sunk to levels of 10 or lower. This happened, for example, in the 15 years after 1932, when the Cape hit 6, and 1982, when it hit 8.

Conversely, the worst returns have been made after the Cape has peaked above 25. That happened after 1929, when the Cape reached 30, and 2000, when it hit 44.

Today the US Cape is 25.5 and falling. That’s a medium-term equity market warning. So is Ireland’s elevated Cape of 27.4. Those looking for long-term equity bargains might look at the markets in Brazil (Cape of 7.4), Poland (9.1) or the Czech Republic (9.4).

And, if you want a bargain and have a stomach for risk, you can try Russia, where the Cape is a measly 4.6.

IMI . Picture Conor McCabe Photography.

Cormac Lucey is the Programme Director of the IMI Diploma in Business Finance.

Cormac is a Financial Services Consultant and Contractor who has previously worked with PricewaterhouseCoopers, Rabobank Frankfurt and the Department of Justice.