In December 2013, Shiller's CAPE value was 24.9, more than fifty per cent above its long term average. Many portfolio managers believed the market was grossly expensive. "The market is steeply overvalued, leaving investors with the prospect of low, single-digit long-term expected returns," wrote William Hester, CFA one year ago. He was one of many to have believed it.
Little wonder that most US money managers were underweight in stocks—and thus missed the 2014 bull market. Many hedge fund managers were short stocks and got hammered.
The problem has been in the metrics. Shiller's famous CAPE has a serious flaw. The CAPE is the valuation ratio that compares the S&P 500 Index to the 10-year average of inflation-adjusted earnings. The purpose of the 10-year averaging is to smooth out cyclical fluctuations of corporate earnings.
So far, so good. The problem is the inflation adjustment. Professor Shiller, as most other academics, knows no other measure of inflation but Consumer Price Index. However, the CPI has been significantly modified since the 1980's. It has been actually modified to the point of irrelevance. Moreover, a consumer price index is a wrong tool to adjust corporate earnings for inflation by definition.
Deflating profits by consumer prices is tantamount to dividing apples by oranges: simply wrong. Figures such as sales or profits must be discounted by very different inflation measures. Money supply—the original measure of inflation—comes to mind.
This is how Shiller's CAPE would look when the Money Zero Maturity aggregate is used instead of the CPI starting from 1980:
The corrected CAPE would have been equal to 19.2 in December 2013. This was still above the long-term average (by almost a quarter) but less misguided than the original value of almost 25.
The most recent corrected CAPE (as of December 2014) equals 20.9, which appears neither too low nor too high. When expressed as earnings-to-price ratio it is equal to 4.78 per cent. Compared to the 30Y T-Bond yield to maturity of 2.82 per cent, the S&P 500 still looks like a buy.
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