Tags: Shiller | CAPE | PE | ratio

Morningstar's Lee: Shiller P/E Ratio Is Under Attack

By    |   Friday, 14 March 2014 07:02 AM

The Shiller cyclically adjusted price-earnings (CAPE) ratio, a popular stock valuation method, is under attack.

"The controversy is hugely important," writes Morningstar strategist Samuel Lee, noting that valuation metrics are critical for equity investors.

One major controversy with the Shiller CAPE - which is calculated by using inflation-adjusted stock price averages and earnings for the last 10 years, is its reliance on generally accepted accounting principles (GAAP), he contends.

Editor’s Note:
Pastor Explains His Biblical Money Code for Investing


For years, companies following the accounting rules recorded gains and losses when assets were sold. Then GAAP implemented fair value accounting, requiring firms to value assets and liabilities at current value.

Firms marked down assets that lost value and took a hit to earnings. If not marked down, the assets are held at historical cost. On the other hand, firms cannot mark up assets that increased in value until they are sold.

"As critics rightly note, the move to fair value accounting was a big deal," Lee notes. "It injected a lot of volatility into earnings."

Data clearly show earnings started fluctuating wildly, especially after huge losses after the dot-com crash and financial crisis.

Critics say the "asymmetric" rules counting losses immediately, but not counting gains until sale, push earnings into the future and push the Shiller P/E down. Operating earnings, they argue, provide a more accurate reading, since they don't include one-off items.

Another issue with GAAP is that declining interest rates may persistently bias earnings upward. Since valuations are based on Treasurys, declining rates push future cash flows up, prompting immediate capital gains. That's happened since the early 1980s. Of course, rates can't keep falling.

"If interest rates experience a sustained rise, resulting in capital losses, corporate America's earnings will likely be hurt," Lee predicts.

The Shiller P/E uses the 130-year average because that's how much data Shiller has compiled.

Big mistake, critics say. "They argue equity valuations have achieved a permanently higher plateau because circumstances have changed for the better," Lee says, listing better monetary policy and corporate management.

"I wholeheartedly agree. Comparing today's Shiller P/E with its 130-year average will likely lead you astray," he adds.

"So what can be said about Shiller P/E? It's imperfect, but the alternatives are worse."

"The Shiller CAPE, as constructed by its proponents, utilizes inconsistent data," writes finance blogger Jesse Livermore on his Philosophical Economics blog.

During the last 23 years, the Shiller P/E has failed to revert to its mean, he says. "Either the 'normal' levels of the metric have shifted significantly upwards over the last few decades, or the metric is broken. Which possibility is it? In my view, both."

Editor’s Note: Pastor Explains His Biblical Money Code for Investing

© 2021 Newsmax Finance. All rights reserved.


InvestingAnalysis
The Shiller cyclically adjusted price-earnings (CAPE) ratio, a popular stock valuation method, is under attack.
Shiller,CAPE,PE,ratio
453
2014-02-14
Friday, 14 March 2014 07:02 AM
Newsmax Media, Inc.
 
Newsmax TV Live
 

Newsmax, Moneynews, Newsmax Health, and Independent. American. are registered trademarks of Newsmax Media, Inc. Newsmax TV, and Newsmax World are trademarks of Newsmax Media, Inc.

NEWSMAX.COM
MONEYNEWS.COM
© Newsmax Media, Inc.
All Rights Reserved