Why CAPE is relevant: A current study

Ken Fisher's critique of the cyclically adjusted price-to-earnings ratio (CAPE) here on 6 March was refreshing - for awareness, CAPE is partly distorted by a 10-year historic view still including the earnings trough from The Great Recession.

Many people regard CAPE as a market timing tool, but if you followed it reasonably closely you would have been largely out of equities since 2013. I've noted in macro pieces before, even Professor Robert Shiller (who popularised CAPE) has said markets could rise further despite the ratio being around historic highs.

The problem seems to be that expectations got too high for this "indicator". It became inextricably tied with Shiller whose March 2000 book Irrational Exuberance was published at the height of the dot-com boom, arguing extensively how markets were overvalued and which promptly collapsed.

But there's a much longer historical context: from 1934 Benjamin Graham and David Dodd (who laid the intellectual foundations for value investing) tried to steer attention off reported earnings per share (EPS) which convey a short-term focus and possibly enhanced 1920's market overvaluation. They argued for smoothing PE ratios, dividing market price by the average of 10 years' earnings, adjusted for inflation.

Such an approach favours established cyclical firms than those pioneering or restructured, where history counts less. And, when CAPE is applied to a market index, it can get distorted by macro influences – especially the monetary stimulus that became institutionalised by central banks, not just as a means to cope with the 2008 crisis but low growth/inflation thereafter.

Respecting limitations with any long-term indicator, I suggest CAPE is useful as one clue in weighing the probability of events where indeed you should look forward and prioritise fundamentals. That its value is over 29 times on the S&P 500 index, coinciding with levels before the 1929 and 2000 crashes, makes it intrinsically high even if distorted.

Crucially, in shares, you are looking for inflection points, be they changes in corporate prosperity versus share values or macro events versus markets. CAPE's simple message at this point is to heed what risks there are for a change in market sentiment.

Are Trump's plans already running into trouble?

I've warned in these macro pieces, President Trump's reflation plans are liable to get bogged down in the US Congress given they appear to need a significant rise in the US debt ceiling. Possibly his infrastructure programme could involve private sector funding, but tax cuts look more like a trade-off with public debt.

Already his "Muslim travel ban" and healthcare reforms are being thwarted. Even if modest progress is made on supply-side measures e.g. to reduce America's 35% corporation tax – among the highest in the world – the dilemma would be economic stimulus provided at a time of relatively full employment and after one of the longest (if steady) cyclical upturns. Productivity remains chronically weak. Thus, inflation and interest rate rises are more likely outcomes, potentially a recession.

US credit/money supply is tightening

Money supply can be a fleeting variable, but changes often presage the wider economy by a few months. US commercial lending appears to have peaked last December and is now falling, thereby reducing money supply figures. This could be a short-term issue of firms pausing to see what the Trump administration actually does, although it only needs to persist for a slowdown to become self-fulfilling.

Moreover, the wider context is that the Federal Reserve is now more inclined towards an interest rate-raising cycle due to the tight US labour market, than providing stimulus like in past years.

Not to emphasise one quarter's corporate earnings, but pay attention to any trend in US Q1results soon to unfold. I've seen analysis in the UK how consensus 2017/18 forecasts for US earnings assume something like 4.75% GDP growth and flat labour costs, both unrealistic.

Fundamentals, therefore, imply a risky environment for equities hence a high CAPE ratio tells us to beware an inflection point.

Global context is shifting towards inflation

Barely a year ago, deflationary fears swept markets, yet inflation is now returning. This has mixed implications for equities, which can offer protection where companies have enough freedom to price, albeit less protection if weaker consumer spending slows real GDP growth.

We see this dilemma already in the UK where one member of the Bank of England's monetary policy committee reckons a pre-emptive interest rate rise is needed.

Yet consider the effect on consumer spending where credit hit an 11-year high in February, just as real wages are falling. Consumers borrowed £1.4 billion net of repayments in personal overdrafts and on credit cards, maintaining the annual rate of growth in consumer credit at 10.5%. The overall level of UK consumer indebtedness hasn't yet reached its 2007 peak, but the borrowing rise reflects those people struggling to get by each month as rents and other living costs rise, than discretionary spending.

Internationally, China is exporting inflation now it's risen above 5%, and tighter monetary policy to contain it may result in softer growth. In Europe, the story may be more encouraging for equities given inflation is expected to hurt bond values and drive a re-rating of stocks, although that comes across as speculative.

The common denominator is a net tightening of policy as inflation returns and, if Trump does prove successful with a short-term stimulus, inflation could advance to require a more combative approach globally via interest rates. Amid low productivity rates and no comfortable trade-off area between growth and inflation, a high CAPE ratio makes equities look exposed.

2017 should therefore be a litmus test

Ken provides a comprehensive critique of CAPE: even if the ratio is used "properly", equity prices are determined by supply and demand and no-one can predict far-future supply to usefully project returns.

CAPE relies on past information markets have already discounted, hence it's a distraction. Best do the opposite of what it implies: folks presently fear CAPE, thus scepticism lingers, but animal spirits are awakening (helped by Trump), hence a melt-up in stocks lies ahead.

My perspective is warier, the macro context signalling rising risks for equities which coincide with this technical ratio on a high valuation, also very strong stock charts since 2009. Wealth protection being the first objective, it's time to take care.

Whether US equities advance or break down henceforth, taking other markets along, should validate - or otherwise! - CAPE's role in investment analysis.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.