Monday, July 25, 2016

New(ish) paper on the Shiller CAPE ratio, by J. Siegel

Published in the May/June issue of the Financial Analysts Journal (vol. 72, no. 3). I'm not sure it it's gated, so you can find a working paper (from 2013!) version here.


Robert Shiller’s cyclically adjusted price–earnings ratio, or CAPE ratio, has served as one of the best forecasting models for long-term future stock returns. But recent forecasts of future equity returns using the CAPE ratio may be overpessimistic because of changes in the computation of GAAP earnings (e.g., “mark-to-market” accounting) that are used in the Shiller CAPE model. When consistent earnings data, such as NIPA (national income and product account) after-tax corporate profits, are substituted for GAAP earnings, the forecasting ability of the CAPE model improves and forecasts of US equity returns increase significantly.

The gist of the paper:

"In this article, I offer an alternative explanation of the elevated CAPE ratio. The nature of the earnings series that is substituted into the CAPE model has not been consistently calculated for the long period over which Shiller has estimated his CAPE equations. Changes in accounting practices since 1990 have depressed reported earnings during economic downturns to a much greater degree than in the earlier years of Shiller’s sample."
"Companies report their earnings in two principal ways: reported earnings (or net income) and operating earnings. Reported earnings are earnings sanctioned by the Financial Accounting Standards Board (FASB), an organization founded in 1973 to establish accounting standards. Those standards—the generally accepted accounting principles, or GAAP—are used to compute the earnings that appear in annual reports and that are filed with government agencies (earnings filed with the IRS may differ from those filed elsewhere). GAAP earnings, which are the basis of the Standard & Poor’s
reported earnings series that Shiller used in computing the CAPE ratio, have undergone significant conceptual changes in recent years. 

A more generous earnings concept is operating earnings, which often exclude such “one-time” events as restructuring charges (expenses associated with a company’s closing a plant or selling a division), investment gains and losses, inventory write-offs, expenses associated with mergers and spinoffs, and depreciation or impairment of “goodwill.” But the term operating earnings is not defined by the FASB, and companies thus have some latitude in interpreting what is and what is not excluded. In certain circumstances, the same charge may be included in the operating earnings of one company and omitted from those of another. Because of these ambiguities, several versions of operating earnings are calculated."
"The definition of reported earnings has undergone substantial changes in the last two decades. In 1993, the FASB issued Statement of Financial Accounting Standards (FAS) No. 115, which stated that securities of financial institutions held for trading or “available for sale” were required to be carried at fair market value. FAS Nos. 142 and 144, issued in 2001, required that any impairments to the value of property, plant, equipment, and other intangibles (e.g., goodwill acquired by purchasing stock above book value) be marked to market.9 These new standards, which required companies to “write down” asset values regardless of whether the asset was sold, were especially severe in economic downturns, when the market prices of assets are depressed. Furthermore, companies were not allowed to write tangible fixed assets back up, even if they recovered from a previous markdown, unless they were sold and recorded as “capital gain” income."
 "A distortion related to the Standard & Poor’s methodology for computing the P/E of an index—what I call the “aggregation bias”—overestimates the effective ratio of the index when a few companies generate large losses, as happened during the financial crisis. S&P adds together the dollar profits and losses of each S&P 500 company, without regard to the weight of each company in the index, to compute the aggregate earnings of the index. This procedure would be correct if each company were a division of the same conglomerate and one wished to determine the P/E of that conglomerate"
"Because of changes in the definition of GAAP earnings, it is important to use a definition of corporate profits that has not changed over time, as in the series computed by the national income economists at the Bureau of Economic Analysis (BEA), which compiles the national income and product accounts (NIPAs)."
"In forecasting future 10-year real stock returns, the highest R squared is achieved by using NIPA profits for specifications of the CAPE regression, with either the price index portfolio or the total return portfolio."

Siegel offers alternative estimates of how over-valued the S&P is, according to each CAPE measure, as well as estimates of future returns. The CAPE that uses the NIPA profit measure produces the lowest over-valuation and the highest expected returns. I'm generally sceptical of such estimates, so I won't go into those details.

What I got from this paper is a reminder that the S&P measure of profits (and perhaps other measures that rely on reported earnings) has changed over time, due to accounting changes, so one has to be careful when using it.

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