By Rob Bennett

Shawn Tully has written an important article for Fortune (CAPE Fear: The Bulls Are Wrong. Shiller’s Measure Is the Real Deal) explaining why a frequently voiced criticism of Robert Shiller’s Cyclically Adjusted Price Earnings (CAPE) metric is off the mark.

The criticism is that today’s CAPE is artificially high because the past decade of earnings (the denominator in the CAPE metric) includes the time-period in which the financial crisis of 2008 brought earnings to very low levels. The conventional price/earnings ratio, which takes into account only a single year of earnings, offers a less alarming assessment of today’s level of overvaluation because the exceptionally low earnings numbers in the time immediately following the crisis do not influence it. The thinking here is that, as we move far enough away from the crisis years for those poor earnings years to no longer be counted in calculation of the CAPE, the indication of a severe overvaluation problem will to a large extent magically disappear.

Tully argues that the earnings number used in today’s CAPE is not artificially depressed. He explains that: “I calculated the ten-year average of real profits for six decade-long periods starting in February of 1959 and ending today, (the last one running from 2/2009 to 2/2019). On average, the adjusted earnings number rose 22% from one period to the next. The biggest leap came from 1999 to 2009, when the 10-year average of real earnings advanced 42%. So did profits since then languish to the point where the current CAPE figure is unrealistically big? Not at all. The Shiller profit number of $91 per share is 36.1% higher than the reading for the 1999 to 2009 period, when it had surged a record 40%-plus over the preceding decade. If anything, today’s denominator looks high, meaning the CAPE of almost 30 is at least reasonable, and if anything overstates what today’s investors will reap from each dollar they’ve invested in stocks.”

“Earnings in the past two decades have been far outpacing GDP,” according to Tully. “in the current decade, they’ve beaten growth in national income by 1.2 points (3.2% versus 2%). That’s a reversal of long-term trends. Over our entire 60 year period, GDP rose at 3.3% annually, and profits trailed by 1.3 points, advancing at just 2%. So the rationale that P/Es are modest is based on the assumption that today’s earnings aren’t unusually high at all, and should continue growing from here, on a trajectory that outstrips national income. It won’t happen.”

The article states that: “It’s true that total corporate profits follow GDP over the long term, though they fluctuate above and below that benchmark along the way. Right now, earnings constitute an unusually higher share of national income. That’s because record-low interest rates have restrained cost of borrowing for the past several years, and companies have managed to produce more cars, steel and semiconductors while shedding workers and holding raises to a minimum. Now, rates are rising and so is pay and employment, forces that will crimp profits…. The huge gap between the official PE of 19 and the CAPE at 30 signals that unsustainably high profits are artificially depressing the former. and that profits are bound to stagnate at best, and more likely decline.”

Tully concluded that: “In an investing world dominated by hype, the CAPE is a rare truth-teller.”

I would like to add a point of my own that I think that those trying to assess the value of the CAPE metric might want to consider. Shiller’s key insight is that, during times of high valuations, it is not economic realities that are the primary determinant of stock prices but investor emotion. That is, the gains produced in bull markets are Pretend Money. Inflated numbers appear on investor portfolio statements for a time, making investors feel excessively confident re their financial futures. But the Pretend Money disappears in time because it is not rooted in anything real.

It is important to understand that the Pretend Money does not just fool investors. It fools business executives seeking to earn profits. When portfolio statements overstate investors’ wealth, those investors feel comfortable spending more than they otherwise would. The added spending inflates profits for all types of businesses. But of course the added spending is temporary. When valuation levels drop to fair-value levels, the entire economy contracts as the Pretend Money spigot is turned off.

The criticism of CAPE is driven by the idea that the time-period immediately following the 2008 crisis was highly unusual. Now that we have that behind us, we should be looking forward to more normal economic times and the flashing red light sent by today’s scary CAPE number is unwarranted.

The full reality, however, is that valuations are back at the levels that brought on the 2008 crash. There are trillions of dollars of Pretend Money generating lots of artificial economic growth today. If valuations fall sharply, as they always do when they rise as high as they are today, earnings will crash and the warning being flashed by today’s CAPE number will be seen to have been a legitimate one, not an artificial one caused by events that transpired nearly 10 years ago.

The conventional view is that it is the economy that affects stock prices. But, if Shiller is right that stock prices are heavily influenced by investor emotions, it is just as much so or more so that stock prices affect the economy. If that is so, we cannot evaluate the merit of the CAPE metric by considering only the economic factors focused on by CAPE’s critics. We have to take into consideration how today’s irrational exuberance will be hurting us in days to come.