Screen Shot 2017 07 12 at 8.53.30 AMMany ways to measure the stock market’s value are trading at or above their historical average.

They include the most popular one: the Shiller price-earnings ratio, which on Tuesday was more than 10 points above its long-run average of 16.76.

It’s also called the cyclically-adjusted price-earnings (CAPE) ratio because it takes the price of the S&P 500 and divides it by the average of ten years worth of earnings. By averaging, the ratio accounts for the noise that different business cycles and other temporary events introduce. 

When the PE ratio is above its historical average — like it is now — the market is considered expensive. 

“It’s a flawed metric,” said David Bianco, the chief investment strategist for the Americas at Deutsche Asset Management, at a media briefing on Tuesday. “When it comes to something like the Shiller PE … that deserves to be trashed. We really have to move on and not even talk about that anymore.”

He added that as economists question the usefulness of principles like the Taylor Rule and the Phillips Curve, investors, too, should rethink the Shiller PE. 

Bianco has a longstanding disagreement with the CAPE ratio. He reiterated it in the context of forecasts that stock market returns would be lower for the rest of this cycle given the market’s stretched valuation. 

What’s wrong with Shiller PE?

The CAPE ratio accounts for inflation in its earnings adjustment. However, earnings should always rise more than the inflation rate because companies don’t pay out 100% of their earnings, Bianco said. 

The share of profits that companies don’t pay out as dividends and keep to reinvests or debt payments — retained earnings — aren’t accounted for in the Shiller PE, according to Bianco. 

“When you retain earnings, there should be earnings growth above inflation,” he said.

“If a management team came in and said ‘we grew earnings by inflation over the past decade’, you’d probably say ‘get out.’ Unless they paid out 100% of their earnings as dividends. If they’d been retaining any significant portion of their earnings for reinvestment, the earnings growth should have been much better than inflation.”

The self-titled Bianco PE ratio takes the last 10 years of earnings and adjusts not just for inflation, but also for the retention ratio and an estimate of the rate of return on that retention capital, which he pegs at 6%. In Bianco’s view, that’s a better way to make a time-value adjustment to historical earnings.

Either way, the market is expensive, he said.

“The Shiller PE is not the CAPE, Bianco said. “It’s one form of the cyclically adjusted PE, and it’s a form of the cyclically adjusted PE that I think is flawed.” 


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