Take a look at the Shiller P/E. Notice how it has been perpetually high since really around 1987. In 2008 it did drop but not a real hard drop since the P/E was still around 15. So what has happened? Is it all the QE or is it the change from a manufacturing to a service economy? Is the Shiller P/E broken and really something someone shouldn’t even take into account?
If we get the rise in productivity, as some people are talking about, in AI will Shiller be permanently broke?
Andy
I am not the authority on these matters, but on matters generally: Any system that has not performed to it’s well-researched specifications for 35 years is probably no longer operative.
It’s possible that AI could produce an infinite PE ratio and a level of wealth that defies description. If taxed appropriately, AI could elimate poverty, hunger and inequality (i.e., Universal Basic Income). If we maintain the current 0% tax rate on inherited wealth, AI will produce a handful of oligarchs and a world of serfdom.
intercst
The rise from the mid-90s was predicated on easy money to change the date.
The rise from 2010 was predicated on very low-interest rates that raised asset values, along with easy money.
From here on out for a few decaes the longer term trend in rates is higher. We may not see the current high for several years but we will see rates overall trend upwards. This means a tighter money supply and lower asset prices.
EXCEPT that the economy will be getting filthy rich which will raise asset prices. That is a different more important pressure. We can have lower Shiller readings with higher asset values.
Further out in time, there will be more business borrowing by a rising middle class which will open up the the money supply.
Note I do not buy into AI doing much for productivity.
My first thought was rising PE was linked to rising debt to equity ratio. As equity approaches zero, or goes negative, return on equity approaches infinity, which some might think merits a higher PE. But I am having difficulty finding a clean graph of corporate debt/equity ratios. I keep coming up with total corporate debt, or debt as a percent of GDP.
Did find one graph of net debt to EBITA, but the time scale is shorter than I wanted, and it still isn’t what I was really looking for.
That is a shame the chart cuts off in 2015. That is a lot of data missing. It would be interesting. That goes to outsourcing. The party that took power in 2016 may have disappeared that data. It could be trouble for them.
That’s actually not unusual in the United States. People have long be told that home ownership with a 4% average return over the past 100 years is the cornerstone of family wealth while the stock market has returned 10% per year over the same period.
And don’t get me started on the idea that “trickle down” was going to do anything to help the middle-class.
intercst
Yes, it would be better if it covered a longer time period, but it still isn’t what I am looking for. FRED has plenty of charts of debt to “market value” of equity, but I want debt to balance sheet equity. As we see every quarter, management is burning balance sheet equity to inflate the “market value” of equity. Not every company is Billions into negative equity, like Boeing, but that is the trend. Even Walmart is burning balance sheet equity these days.
Steve
With the money infused into infrastructure, the factories are now opening.
We have to produce our way through all of that.
I’d like to know what the data is beyond 2022.
The dumbest thing I see the “news” do is ask “is this a good time to buy a house?”, because they invariably are asking either a real estate salesman, or a mortgage salesman.
Steve
Heh heh. I seem to recall somebody refer to it as voodoo economics. Like who can live on a trickle anyway?
CAPE might be broken. My preferred use is:
projected 10-year future CAGR = inflation + 1/CAPE
But this is of little use for most people. Interest rates and corporate effective tax rates might affect the CAPE predictions, and maybe these have bottomed out. Interest rates and corporate effective tax rates can’t go much lower than 0%.
Example: CAPE was about 28 in January 1997. Projected real return was 1/CAPE = 1/28 = 3.6%. Actual CAGR from Jan 1997 to Dec 2006 was about 8.3%. Inflation was about 2.5%. Actual real CAGR = 5.8%.
Example 2: CAPE was about 21 in January 2012. Projected real return was 1/CAPE = 1/21 = 4.8%. Actual CAGR from Jan 2012 to Dec 2021 was about 16.4%. Inflation was about 2.2%. Actual real CAGR = 14.2%.
Real 10-year interest rates have also dropped since 1987: from about 3% in 1997 to 0% in 2012.
Price–Earnings Ratios as Forecasters of Returns: The Stock Market Outlook in 1996, Posted 7/21/96
“Looking at the diagram, it is hard to come away without a feeling that the market is quite likely to decline substantially in value over the succeeding ten years”
http://www.econ.yale.edu/~shiller/data/peratio.html
Maybe CAPE could be improved on by taking into consideration that:
Corporate business: Profits before tax (without IVA and CCAdj) (A446RC1Q027SBEA)
Corporate Profits After Tax (without IVA and CCAdj) (CP)
effective tax rate = 1 - (Corporate Profits After Tax)/(Profits before tax)
The effective corporate tax rate was 17% in 1997 and -3% in 2012.
I like the concept of CAPE but would never really use it. Buying shares becomes much more of an accounting study than a market study.
A long time ago in a far away country when I first heard about the Shiller CAPE ratio I had a look at it and it made no sense to me.
The P/E ratio varies significantly between businesses and industries and businesses and industries vary over time. In effect business has become more productive over time. Shiller CAPE effectively claims that nothing ever really changes.
But Americans love magic numbers so Shiller CAPE remains a Zombie Dead Man Walking!
The Captain
It is supposed to marry up market forces with economic forces but not explain the forces just diagram them in a set of abstract constructs.
The accounting drops out. Without accounting and opportunity costs you have no investment. By the time you figure out the CAPE, you have no view of your actual investment or the economic horizon.
Because housing has parameters that fall closer to CAPE matters like the FED’s policies on money supply and rates altering the future growth of the GDP you are given a false sense CAPE might be accurate going forward. CAPE surprises by being very limited no matter how expansive the concepts are.
Maybe “broken” is a function of interest rates? At least partially. I don’t mean instantaneous interest rates, but rather trends and averages (after all, interest is almost always incurred over a period of time, not instantaneously). It is possible that it all depends on where interest rates settle over the next decade or two. If they settle in the 3-4% or higher range then all these trend indicators (Schiller PE, CAPE, etc) may go back to the way they were (i.e. they were “broken” during the super low interest rate period), but if they settle back near or below the 2% range then they may continue as is (i.e. they were not “broken”).
Here’s a chart of 10-year interest rates -
I think that makes a lot of sense. When the risk free rate is essentially zero, you are willing to pay more for return, thus a higher P/E.
I thought it might have been QE but Mark and your explanation makes a lot of sense. Maybe QE drove down the interest rates? So if they suck money out of the economy interest rates should be higher?
Andy
Presumably that would cancel out, because if everyone is using AI, some companies would be incentivized to lower prices, hence earnings would be lower too.
My personal believe (and I have no way to prove this) is that due to the rise of the 401(k), index funds, and discount brokers, investors are simply willing to accept higher premiums for stocks than they used to. It used to be 15 times earnings on average. Now maybe the new normal is 20 times. Again, just speculation.
Interestingly, the premium for buying a small private company is much, much lower. You can buy a bike shop or restaurant for 2-3 times earnings. This is why private equity companies are scooping up Ma and Pa funeral homes and mobile home parks.
That does not explain the first part of the rise in CAPE 1997 to 1999 PE values. Instead, excessively easy money plays a bigger factor, not necessarily lower rates. The rates are relative to the more recent history. The money supply has a different relationship with money on the sidelines.
