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« Weighing the Week Ahead: Any Help from the European Summit? | Main | Weighing the Week Ahead: Bring on the (Economic) Evidence! »

May 21, 2012


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The reason that "Shiller disciples" care about profit margins is simple: it shows why they are right.

Shiller disciples believe that the 12 month trailing PE is a bad measure of value and that the reason why it is currently giving a misleading reading is because profit margins are unusually high. When profit margins regress to the mean, then the 12 month PE will come back in to line with the CAPE, unless the market falls.

It would be extraordinary if Shiller disciples didn't care about profit margins, because the fluctuations in profit margins over time are a key reason that Shiller (plus Ben Graham and others) designed the CAPE in the first place.

I agree with much of what is said here. Comments: look ahead bias is obvious but rarely mentioned. The effect of interest rates today on profit margins gets little attention as well. Compare interest costs as a percentage of net profit margins 10 years ago versus today and you can see "a permanently higher plateau" for NPM due to lower interest costs for perhaps 10 years (irony intended). But most importantly, there is no time horizon shorter than 10 years for which the Shiller CAPE has ANY predictive value for subsequent stock returns. I am always astounded to read folks throwing the Shiller CAPE around having not done the elementary analysis to check if it is predictive!

Chris of Stumptown

I am not sure what constitutes a "Shiller disciple," but I've followed the argument for a while now.

As the name would indicate CAPE does inform on future earnings. That's what "cyclically adjusted" means.

As I see it, the profit margin question is a distinct issue. The current high margin regime has persisted and even grown across multiple cycles. The "disciples" claim that mean reversion always occurs, but they have been saying this for at least a decade.

One reason to care about CAPE might be that it bears a close relation to Q, but they do not provide the same signal at the same time. Given that replacement cost is quite slow to change, CAPE reverts to Q. Andrew Smithers has quite a bit of information on this.

Octavio Richetta

I don't see any contradiction here. The focus of both 1. and 2. Is reversion to the mean. So there is only one windmill you would have to charge against; i.e., provide evidence that reversion to the mean is nonsense.


I think mgnyc is absolutely correct. The Shiller metric seems to have "worked" at some time in the past, but it didn't work at all for a number of years, and it's not working very well now, so an excuse must be found to make it work again for the investors that have grown fond of the theory.

I could almost understand issues raised about negative earnings or low inflation distorting P/E 10 and requiring an adjustment, but adjusting for margins strikes me as akin to data mining.

And my own objections, for which I claim no particular originality:
1) This metric is really fraught with look-ahead bias. We can't go back to 1900 and buy or sell based on a long-term average that won't exist for another 100 years.
2) The series may not be mean reverting; we don't have nearly enough data or knowledge of the processes.
3) Victor Niederhoffer did a study of P/E ratios (a full chapter in "Practical Speculation") and concluded that you can't make money from them, partly because of after-the-fact corporate earnings data revisions which contaminate the S&P database.

I sure wish investing was as easy as watching a single number go up and down.


Most investors who claim to use a single dimensional metric like a low Shiller's 10YR P/E are merely using it to justify doing or not doing something. The proof is that they then go to contortions to condition their "metric" of choice on other variables. In this case, the notion of profit margins declining.

The truth is, whenever a contrarian buy signal appears, most people get anxious and look for sophisticated ways to ignore it. Thus, it allows them to pursue the status quo (i.e. doing nothing and "waiting" for a bottom after the fact) vs. actually taking a view and acting on it.

We have seen that our particular investment horizon is filled with those who only think about managing their risk vs. looking for objective opportunity. Just look at the current market. There are a large number of stable stocks paying some dividends with single digit P/Es. If we invert the yield to the stock holder, you get greater than 10% earnings yields plus a dividend to boot. On a tax adjusted basis, this blows away the 10-year treasury or any other "safe" asset. However, in order to avoid the mark-to-market volatility, people can't bear to invest in such "risky" assets. It just hurts their gut to do so.

As a result, they come up with ridiculous justifications, contrary to their stated philosophy, of why they AREN'T buying, when the real reason is that they have an incredibly short-term investment horizon (i.e. they have no real long-term conviction or their investors have no long-term trust in them).

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