More Thoughts on the CAPE and Valuations

August 20, 2014

2 minute read

I’ve made my opinion on valuations and the use of CAPE pretty clear - these sorts of metrics don’t tell us much about the macro environment because the whole idea of ” value” is dynamic and evolving. If I am right then trying to calculate a market “value” through these types of metrics is likely to mislead you into thinking that the market is static and more predictable than it really is.

The point is, if valuations and market perceptions are as dynamic as I believe then the history of something like CAPE really doesn’t tell us much at all. After all, “value” is really all in the eye of the beholder. If investors are willing to pay more for stocks today than they were in 1950 then maybe a CAPE of 15 has no bearing on what a CAPE of 25 means. That is, stocks could simply be perceived differently than they were in the 1950s. Perceptions change. And there’s no reason why stocks can’t be perceived to be inexpensive at a CAPE of 25 just because they once sold at a CAPE of 15. In other words, what if a CAPE of 35 is the new “expensive”? Now, I don’t know if that’s true, but in the process of managing one’s risk I think you have to consider that possibility.

I bring all of this back up because Brad Delong wrote a nice piece citing a similar view in response to Robert Shiller’s NY Times piece this weekend. Delong basically notes that stocks were undervalued for no good reason in the past:

“Given the large number of investors and institutions in our economy with very long time horizons that thought to be in the stock market for the long-term–insurance companies, pension funds, rich individuals with grandchildren–for me the anomaly does not seem to be a CAPE of 25 (or, given historical real returns on other asset classes and very low current yields on investments naked to inflation risk, 33) but rather the CAPEs of 14-20 that we saw in the 1980s, 1960s, 1950s, 1900s, 1890s, and 1880s that Robert Shiller appears to think of as “normal” and to which today’s CAPE should someday return. “

I am going to be blunt – I have no idea if any of this is true. I don’t know what the “value” of stocks are today. And I don’t think anyone else really does. And I think trying to put a value on them through these sorts of metrics is just a big waste of time that leads some people to believe they’ve been able to pinpoint the “value” of stocks at present when the reality is that they’ve simply tried to calculate, with precision, something that is very imprecise (human perception). Therefore, if “value” is just another dynamic and evolving concept based largely on human perception then calculating it at any given time is likely to mislead you more than it’s likely to help you.