Shiller backward 10 year P/E estimate off this decade?

[original mungerville]

It has been my view that the Shiller backward 10-year P/E method of estimating the priciness of the market underestimates just how pricey it has become.

 

If you listen to Shiller at the below link he is basically saying its at 23 times which is above average but not a super rich valuation.

http://www.valueinvestingworld.com/2013/04/robert-shiller-on-wealthtrack.html

 

However, Hussman's analysis (see link) also corroborated by GMO is compelling. Just eyeballing the second graph over the past decade ie 2003 - 2012, it looks like profits after tax have been at least, what? more than 33% higher than the long term average (ie long term average of 6% whereas the average over the past 10 years looks to be over 8%, so greater than 33%)

http://www.hussmanfunds.com/wmc/wmc130408.htm

 

So if we reduce the "E" on Shiller's 23 times P/E by the same 23/(6/8) or a Shiller P/E of 23*1.333 = 31 now.

 

Shiller says that in 2000 it got to a P/E of 46 (which is higher than 31 now on this adjusted basis). What's funny is that in the interview, he says the valuations today are not "extremely high, ...its not like 1929, ...I hope, I hope not..." but of course the overvaluation in 2000 relative to GDP was way higher than in 1929.

 

We are not quite in the 1929 vicinity but if corporate margins are indeed artificially inflated, then we might be in the top 5 priciest US markets over the past 100 years:

 

1. 2000

2. 2007

3. 1929

4. 1960s?

5. now?

 

You can thank Q/E and unsustainable spending for recent returns.

 

 

 

 

 

 

 

 

 

[bmichaud]

Munger,

 

Can you explain in a bit more detail why you are adjusting the Schiller earnings downward? Doesn't the Schiller method adjust for margins?

 

Forward SPX sales are about 1,100 - assuming the long run average NPM of 6%, that's about $65 of normal earnings. At 1560, that's a 24x pe. I'd say normal margins are more like 7%, which means $77 and a 20x pe...just to give the market the benefit of the doubt.

 

31x pe seems high but definitely curious as to how you get there. 

[vinod1]

At the end of the day, it is really boils down to what profit margins you believe are normal. Shiller PE is implicitly incorporating some of the higher profit margins of the past decade (mitigated somewhat by the presence of two deep recessions, which might be more than can be expected over a 10 year period). Hussman seems to be 100% certain that profit margins would absolutely without any doubt revert to and probably below the 6% historical margins.

 

I think it is more likely that profit margins are going to be somewhat higher in the future than in the past to say 7 or 8% for maybe another decade or so if not more. If we assume normalized S&P 500 per share sales are about $1000 (compared to $910 at the recession bottom in 2009 and $1075 TTM) and apply 7.5% margins it gives about $75 per share earnings. Put in a 16 multiple, the fair value is about 1200. If we assume interest rates are likely to remain low for a long time and deficits would continue for a long time, then I can see an 18 or even 20 multiple which puts the current value as rich but not outrageously expensive.

 

I do not think it would make sense to both believe that deficits would continue for a long time and also argue that profit margins would revert to historical levels in the near future when as Hussman and GMO articles specify that the deficits are really behind the surge in profit margins.

 

Vinod

[AchilliesValue]

I've read several articles over the last month or so pointing out the current Schiller PE along with its flaws and have a couple of thoughts.

 

1) The corporate margins at historical highs has been discussed at length but I haven't really seen an analysis of what's driving the historical highs.  Is it record low interest rates? Because then we have a serious problem if / when they rise (lowering corporate profits while increasing required earnings yields yikes!).  Is it a improvements in tech / efficiency that have allowed laying off workers? If so we might have a serious structural employment problem meaning unemployment isn't going to get much better.  Is it taxes? I mean were looking at after tax profits when our tax rate has gone from 53% (1946) to where it is now. Or is it something else and is it sustainable?

 

I started to think about any sustainable reasons for the margin expansion. Other than the tax rate (which I think is a big factor when we're talking about a 2% deviation from the long term average and a tax rate that is probably at least 7-8% lower than the long term average) one thing that jumps out is the changes to GAAP accounting over the years and whether or not its even worth comparing "Earnings" now to historical data.  I mean a few things off the top of my head I can think of that could skew the data includes Taxes, amortization of intangibles, accounting for leases, stock compensation, inventory / cogs reporting, etc.  There are examples that would raise reported earnings and others that would lower them and frankly I don't know if it's a wash or whether or not it explains the margin expansion.  I just think it merits pointing out that the "earnings" in 1939 are very different from the "earnings" today.

 

2) Are the piles of cash sitting on corporate balance sheets right now being accounted for in Schiller PE (I don't think it does)? I've been looking for historical data on cash as a % of market cap and haven't found anything recent.  It seems to me that corporations are sitting on a ton of cash as a % of market cap vs historical but I may be wrong.  I suppose you could also make the case that much of this cash is parked overseas and needs to be discounted for taxes but again how much vs the historical data.

 

 

I think having some sort of a EV / EBITDA ratio would be best but there'd still be a lot of flaws.  Along with the accounting which I mentioned you've got to also look at how leveraged companies have been over years which is a factor of availability of financing, trends in D/E ratios, and interest rates. I'm saying this as someone who is a big fan of history and a big believer that history repeats itself but I think when it comes to numbers in a dynamic changing field(financial reporting) its extraordinarily difficult to compare over a long period of time and sometimes even in a short period of time (like the tumultuous 2 decades we've had).  And eventually it all comes back to risk free interest rates (if such a thing still exists) which is the almighty anchor on all other financial assets.  At these rates what's an acceptable earnings yield? 5%? 10%?

[original mungerville]

bmichaud,

 

The Shiller P/E uses the 10 year backward average Es. So the point is what if the Es have been inflated for 10 years? If that were to be the case, the Shiller P/E would have to be adjusted upwards.

 

GMO (and Hussman) provide an economic equation for why the Es have been inflated. This reasoning seems very plausible given savings have been low for over 10 years. The same reasoning may also impact corporate sales so I would not necessarily use corporate sales and give the market any benefit of the doubt.

 

Vinod,

 

I agree, it all boils down to reasonable corporate profits as a percentage of GDP. You seem to think they are sustainable if we keep spending and keep printing - I don't disagree but I don't think the latter two can persist for the next decade. I also think that Japan (or a hiccup in Europe) will halt that party shedding light on the rest of the developed world's spending and printing problems.

 

Corporate profits would decline if the money spigots were turned off or forced by the market to be turned off, so in that scenario cash should be better right now.

 

If enough money was printed to allow corporate profits to maintain their current levels relative to GDP (ie GDP is growing very slowly even so) - so very low corporate profit growth could be expected at best going forward - eventually we get inflation. So all this moves us to is a low real growth stagflationary investment environment for stocks. In this scenario, one would think precious metals such as silver would outperform this low nominal growth in stock prices.

 

Where I come out is a mix of cash and silver is a better positioning for a portfolio than stocks for the next 7 years. I now view this as my neutral position when the stock market is overvalued. 10-15 years ago, my neutral positioning was simply cash. Now with the printing, its cash and silver. However, given we are value investors, that cash layer is actually a fully hedged value portfolio as there is no reason to forgo Alpha just because the market is "high".

 

If stocks were to decline, I would take the hedges off. That's where I come out. 

[bmichaud]

I imagine at every historical peak in profit margins there was exhaustive analysis conducted on why that time was different and how it was difficult to see what would drive margins the other way. It is pretty clear based on the data that deficits are driving margin expansion - both Hussman and Montier discuss at length. Here is Hussman -

 

http://www.hussmanfunds.com/wmc/wmc130408.htm

 

Regarding cash on the balance sheets - yes corporations are much healthier than in 2007, but the SPX in aggregate still has net debt!!! I'm not yet entirely sure why cash can be backed out of the market cap when there is a net debt position....

[bmichaud]

I was under the impression the 2002 and 2008/2009 recessionary earnings included in the Schiller E kind of offset the inflated portion of the balance. I could be wrong though, as you may be right that sales are also inflated.

 

 

 

bmichaud,

 

The Shiller P/E uses the 10 year backward average Es. So the point is what if the Es have been inflated for 10 years? If that were to be the case, the Shiller P/E would have to be adjusted upwards.

 

GMO (and Hussman) provide an economic equation for why the Es have been inflated. This reasoning seems very plausible given savings have been low for over 10 years. The same reasoning may also impact corporate sales so I would not necessarily use corporate sales and give the market any benefit of the doubt.

 

Vinod,

 

I agree, it all boils down to reasonable corporate profits as a percentage of GDP. You seem to think they are sustainable if we keep spending and keep printing - I don't disagree but I don't think the latter two can persist for the next decade. I also think that Japan (or a hiccup in Europe) will halt that party shedding light on the rest of the developed world's spending and printing problems.

 

Corporate profits would decline if the money spigots were turned off or forced by the market to be turned off, so in that scenario cash should be better right now.

 

If enough money was printed to allow corporate profits to maintain their current levels relative to GDP (ie GDP is growing very slowly even so) - so very low corporate profit growth could be expected at best going forward - eventually we get inflation. So all this moves us to is a low real growth stagflationary investment environment for stocks. In this scenario, one would think precious metals such as silver would outperform this low nominal growth in stock prices.

 

Where I come out is a mix of cash and silver is a better positioning for a portfolio than stocks for the next 7 years. I now view this as my neutral position when the stock market is overvalued. 10-15 years ago, my neutral positioning was simply cash. Now with the printing, its cash and silver. However, given we are value investors, that cash layer is actually a fully hedged value portfolio as there is no reason to forgo Alpha just because the market is "high".

 

If stocks were to decline, I would take the hedges off. That's where I come out.

[giofranchi]

At the end of the day, it is really boils down to what profit margins you believe are normal. Shiller PE is implicitly incorporating some of the higher profit margins of the past decade (mitigated somewhat by the presence of two deep recessions, which might be more than can be expected over a 10 year period). Hussman seems to be 100% certain that profit margins would absolutely without any doubt revert to and probably below the 6% historical margins.

 

I think it is more likely that profit margins are going to be somewhat higher in the future than in the past to say 7 or 8% for maybe another decade or so if not more. If we assume normalized S&P 500 per share sales are about $1000 (compared to $910 at the recession bottom in 2009 and $1075 TTM) and apply 7.5% margins it gives about $75 per share earnings. Put in a 16 multiple, the fair value is about 1200. If we assume interest rates are likely to remain low for a long time and deficits would continue for a long time, then I can see an 18 or even 20 multiple which puts the current value as rich but not outrageously expensive.

 

I do not think it would make sense to both believe that deficits would continue for a long time and also argue that profit margins would revert to historical levels in the near future when as Hussman and GMO articles specify that the deficits are really behind the surge in profit margins.

 

Vinod

 

Vinod,

sincerely I hope this doesn’t happen. It would simply mean that profit margins will be 25% higher for the next 10 years than they were on average during the second half of last century: probably the best time for capitalists in the whole history of mankind . Imo, if it actually comes to pass, social unrest will ensue. I wouldn’t run such a risk… even if its probability were very thin… I don’t think it is enough to understand how businesses work, I think we should never lose sight of how people behave too.

 

Furthermore, I don’t think “fair value” for the S&P500 is very useful here. If and when people realize that profit margins are unsustainable at the current level, they will sell. And when people start selling, they have the nasty habit to shoot on the downside.

 

Once again the late Mr. Gary Shilling is the one I agree with. $80 in earnings for the S&P500 and a multiple of 10: S&P500 at 800 is where we might be heading (almost another –50% correction). Because I am a chronic optimist, let’s say I think a –40% correction is possible!  :)

 

giofranchi

 

“As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. One’s knowledge and experience is definitely limited and there are seldom more than two or three enterprises at any given time which I personally feel myself entitled to put full confidence.” - John Maynard Keynes

 

[vinod1]

 

I agree, it all boils down to reasonable corporate profits as a percentage of GDP. You seem to think they are sustainable if we keep spending and keep printing - I don't disagree but I don't think the latter two can persist for the next decade. I also think that Japan (or a hiccup in Europe) will halt that party shedding light on the rest of the developed world's spending and printing problems.

 

Corporate profits would decline if the money spigots were turned off or forced by the market to be turned off, so in that scenario cash should be better right now.

 

If enough money was printed to allow corporate profits to maintain their current levels relative to GDP (ie GDP is growing very slowly even so) - so very low corporate profit growth could be expected at best going forward - eventually we get inflation. So all this moves us to is a low real growth stagflationary investment environment for stocks. In this scenario, one would think precious metals such as silver would outperform this low nominal growth in stock prices.

 

Where I come out is a mix of cash and silver is a better positioning for a portfolio than stocks for the next 7 years. I now view this as my neutral position when the stock market is overvalued. 10-15 years ago, my neutral positioning was simply cash. Now with the printing, its cash and silver. However, given we are value investors, that cash layer is actually a fully hedged value portfolio as there is no reason to forgo Alpha just because the market is "high".

 

If stocks were to decline, I would take the hedges off. That's where I come out.

 

I went from 65% cash to over 80% cash last week. Wanted to cash in my gains given the overall market level. My nominal portfolio exposure is about 60% due to leveraged exposure via LEAPS. I remain very defensively positioned. Wide eyed optimist I am not :)

 

I am more looking at profit margins as a percent of sales (though they are pretty tightly related to profits/GDP as well). My main point is that 6% profit margins are not like the Planck constant or the value of PI, I would expect it to change over time due to structural changes in the economy. To me it seems more likely that it might be higher in the future for various reasons - primary ones being weaker labor power due to emergence of Chinese and Indian work forces into global economy and associated offshoring of low margin production to these countries. I do not want to bet on it but I would not be surprised either if margins are at a slightly higher level in future compared to past. I just disagree with the absolute confidence that Hussman seems to have that they have to revert to 6%. Shiller does not show the anywhere near the same level of confidence in this. In 20 years, we might again go back to 6% margins, that again would not surprise me.

 

The Montier equation showing how deficits are related to high profit margins is technically correct but is very limited use as it most certainly does not show causation. It is an accounting identify, which is true by definition. Sort of like the monetary equation MV = PQ which says as velocity increases prices increases holding others constant. It is true but it tells us zilch. Montier derivation seems to be about the same.

 

Where I am going with all this is that, we need to be much less confident in basing our valuations on the 6% margin number.

 

I can imagine Hussman if he is writing in the 1950s. "We remain 100% hedged because the dividend yield on the stock market is less than the dividend yield on the bonds. The only few times this has been true in the last 75 years, it resulted in losses of 40% to 85%. Suffice to say, we do not speculate and intend to fully protect our shareholders from such unacceptable losses.". He would have waited for 55 years or so until he got the opportunity in 2009.

 

Vinod

 

 

 

[vinod1]

 

Vinod,

sincerely I hope this doesn’t happen. It would simply mean that profit margins will be 25% higher for the next 10 years than they were on average during the second half of last century: probably the best time for capitalists in the whole history of mankind . Imo, if it actually comes to pass, social unrest will ensue. I wouldn’t run such a risk… even if its probability were very thin… I don’t think it is enough to understand how businesses work, I think we should never lose sight of how people behave too.

 

Furthermore, I don’t think “fair value” for the S&P500 is very useful here. If and when people realize that profit margins are unsustainable at the current level, they will sell. And when people start selling, they have the nasty habit to shoot on the downside.

 

Once again the late Mr. Gary Shilling is the one I agree with. $80 in earnings for the S&P500 and a multiple of 10: S&P500 at 800 is where we might be heading (almost another –50% correction). Because I am a chronic optimist, let’s say I think a –40% correction is possible!  :)

 

giofranchi

 

 

No one would be more happy to have the stock market fall 50% than me. My daily prayer goes something like this:

 

"Lord, I do not ask for a bull market. I do not even ask for a bear market. All I ask is for some volatility, is that so freakin too much to ask?"

 

I do not think anyone knows or can know where profit margins are going. It is just too complex. In cases like this, I would always ask myself what would cause me to change my mind? I had written to myself in my investment diary way back in 2004/2005 or so, that if profit margins are going to remain high in another 5 years I should reconsider my assumption of historical profit margins. I used to be fairly confident that profit margins would go down rather quickly below 6% but I was wrong so I am now more agnostic about this.

 

Maybe I am the perfect contrary indicator when a true hard core believer in mean reversion and 6% profit margins, throws in the towel on the 6% margins.

 

Vinod