"Why is the Shiller CAPE so high? In the
last several weeks, a number of prominent academics and financial market
commentators have attempted to answer this question, to include the inventor of
the valuation measure himself, Nobel Laureate Robert Shiller. In this
piece, I’m going to attempt to give a clear answer.
The piece has five parts:
·
In the first part, I’m going to explain why valuations in general are
higher than they have been historically. It’s not just the CAPE that’s
historically elevated; the simple TTM P/E ratio is also historically
elevated, by a reasonably large amount.
·
In the second part, I’m going to highlight the main reason that the
Shiller CAPE has risen relative to the simple TTM P/E over the last two
decades: high real EPS growth. I’m going to introduce a schematic that
intuitively illustrates why high real EPS growth produces a high Shiller CAPE.
·
In the third part, I’m going to explain how reductions in the dividend
payout ratio have contributed to high real EPS growth. In discussing the
dividend payout ratio, I’m going to present a different, potentially more
accurate formulation of the Shiller CAPE, a formulation that conducts the
calculation based on total return instead of price. On
this formulation, the Shiller CAPE falls by around 10%, from 26.0 to 23.5.
·
In the fourth part, I’m going to explain how a secular uptrend in profit
margins has contributed to high real EPS growth over the last two decades.
This effect is the most powerful of all, and is the main reason
why the Shiller CAPE and the TTM P/E have diverged in their valuation signals.
·
In the fifth part, I’m going to outline a set of possible future return
scenarios that investors at current valuations can reasonably expect. I’m
then going to identify the future return scenario that I find most credible."
