A reader and good friend recently sent me an article by Robert Shiller, Nobel Laureate and Sterling Professor of Economics at Yale University. In it, Prof. Shiller uses his own tool for evaluating markets, the so-called C.A.P.E. price-earnings ratio, to make the case that markets are overpriced and that the current market rally is running on emotion. Prof. Shiller is an impressive man, with credentials to boot. His warning that a market correction is in the cards may well be correct, but his prediction gives me the opportunity to warn readers, once again, about the hazards of forecasting and trying to time the market.
The Shiller C.A.P.E. ratio has been around for a long time. It differs in two ways from the conventional price-earnings ratio discussed here. First, where the conventional ratio divides stock prices by recent or future earnings, the Shiller ratio divides the price of stocks by their average earnings over the last ten years. Second, unlike the conventional ratio, the C.A.P.E. adjusts the earnings to take inflation into account. Shiller argues that his two adjustments uncouple his ratio from problems associated with the conventional ratio, especially with respect to recessions. When the economy pulls back, corporate earnings typically drop faster and further than stock prices, so that at market lows, when people should be buying, the conventional price-earnings measure looks high, suggesting that stocks are overpriced. Shiller’s measure, because it uses long and deflated averages, gets away from this misleading effect.
It seems strange to adjust the earnings for inflation. After all, stock prices – the point of comparison – are not adjusted for inflation. The use of a long average introduces other problems. Because earnings rise over time, his use of a ten-year average tends to make the C.A.P.E. ratio look high and the market therefore look overpriced much of the time. Together, these effects make the C.A.P.E. measure give a sell signal even when much else suggests that stocks are a good buy. Here are three illustrative examples:
- C.A.P.E’s implicit pessimism was certainly evident during the earnings and market surge between 2017 and 2019. Leading up to 2017, earnings had disappointed, biasing downward the ten-year deflated earnings average. As a consequence, as 2017 drew to a close the C.A.P.E. measure indicated less attractive market valuations than at any time since 2001. C.A.P.E. followers would have sold and missed the better than 20 percent appreciation in stock prices over the last two years.
- The recovery from the great recession tells a similar story. The C.A.P.E. ratio showed a buying opportunity in 2009, and it was a good opportunity. The market rallied in the years following the recession’s end even though the economic recovery was disappointingly slow. But because the ratio’s use of a deflated ten-year earnings average could not fully capture the post-recession surge in earnings, the Shiller ratio by the end of 2013 showed even less attractive stock valuations than at the start of the great recession. Investors following the ratio would surely have sold and missed the huge gains of the next six years right up to the present.
- In 1990, the C.A.P.E. ratio showed the least attractive valuation in sixteen years. Yet the 1990s saw great market gains of some 274 percent!
The media’s treatment of Prof. Shiller’s efforts adds to the damage of these misleading signals. He is a famous man and receives attention from financial journalists, who broadcast his warnings; several publications have given him his own platform. When his early sell signals prove mistaken, people naturally forget them amid the endless flow of market commentary. And when after several false warnings the market does correct – and there is always a market correction on the horizon – the media says, in effect, that he “got it right again,” or words to that effect.
My point is not to criticize Prof. Shiller and his efforts to chart market valuations. He is a thoughtful and insightful man. However, his is just one of many measures, all of which have their drawbacks. We should not ignore Shiller’s work, despite the C.A.P.E. ratio’s sometimes misleading nature. But we should keep in mind that his measure’s failings show, compellingly, how difficult it is even for even the best-educated minds to forecast market moves and why timing the market is so dangerous, especially using a single measure.