CAPE – is it a useless measure of valuation?

Hi everyone. Just thought I’d share some articles with you again. I don’t tend to talk much about valuation methods, other than my brief overviews at the beginning of various monthly dividend updates. However, this article about CAPE (cyclically-adjusted PE) caught my eye in particular.

Ken Fisher thinks CAPE is useless. I do lean towards his opinion. I think CAPE is too defensive a valuation tool because it doesn’t take several factors into account, which you will learn about in his article.

What I do instead

I tend to look at the standard PE, as well as years of dividend growth, payout ratio/dividend cover, even when the shares go ex-div and when dividends are due to be paid. Then I factor in other things such as the economic cycle, political announcements (e.g. a new focus on infrastructure, house building, etc.).

Anyway, check out the article and let me know what you think by leaving a comment or tweeting me. Is Ken Fisher right about CAPE?

Cheers

P.S. I am not an owner of the stocks Ken recommends and I am not recommending either of them.

3 Comments

  1. Hi M,

    Thanks for pointing me at the article. I tend to agree with John, and I’m possibly even a bit more sceptical.

    I think that CAPE is telling us something about the state of the market, but the problem with all indicators is that they aren’t useful for short-term market timing.

    CAPE also has issues with the way accounting standards have changed since it was formulated. It’s hard to take an indicator too seriously when it says the market is overpriced 90% of the time.

    John does some great stuff mapping the UK indices against their long-term averages and applying mean reversion, but it can’t predict next-year’s performance, only the likely long-term outcome.

    The bond market has been in a bubble for a decade, but it’s not popping.
    Mike Rawson recently posted…Stan Weinstein’s Stage System 1 – Charts and BuyingMy Profile

  2. Hi M

    I would say that CAPE is useless as an index valuation tool about 80% of the time, but the other 20% (10% when CAPE is extremely high and 10% when it is extremely low) it’s very useful.

    Watch this video about the difference between weather and climate, as it’s basically the same idea:

    https://www.youtube.com/watch?v=cBdxDFpDp_k

    When the dog is close to the human you don’t know which way the dog’s going to go because the lead is slack. But when the dog is far from the human and the lead is taut, you know it’s very likely that the dog will head back towards the human.

    The same is true of weather and CAPE relative to their long-term averages.

    This is laid out at length with much empirical evidence in books such as Wall Street Revalued.

    However, it is important to take CAPE with a big pinch of salt and a long time horizon, because CAPE mean reversion can take a decade or more to play out.

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