Problems With Using The 136-Year Mean
In finance, it’s generally best to look at the longest data series available, thereby minimizing the risk of data mining. However, there are several reasons why using a 136-year average for the CAPE 10 will lead to a false conclusion that the market is overvalued.
The Shiller CAPE 10’s historical mean is about 16.7, with the dataset for the full period going all the way back to 1880. The data includes economic eras in which the world looked very different to investors than it does today.
Consider just two examples. For a significant part of the period, there was neither a Federal Reserve to dampen economic volatility nor an SEC to protect investor interests. The presence of both organizations has helped to make the world a safer place for investors, justifying a lower equity risk premium and thus higher valuations. In addition, we haven’t experienced another Great Depression, and there haven’t been any worldwide wars since 1945.
Another reason for the CAPE 10 rising over time is that the U.S. has become a much wealthier country since 1880. This matters because, as wealth increases, capital becomes less scarce. All else equal, less scarce assets should become less expensive.
Changing FASB Rules
Another reason the Shiller CAPE 10’s full-period mean may be an inappropriate benchmark is because accounting rules have changed, impacting how earnings (and thus price-to-earnings, or P/E, ratios) are determined. In 2001, the Financial Accounting Standards Board (FASB) changed the rules regarding how goodwill is written off.
As a post on the blog Philosophical Economics explained: “In the old days, GAAP required goodwill amounts to be amortized—deducted from earnings as an incremental non-cash expense—over a forty year period. But in 2001, the standard changed. FAS 142 was introduced, which eliminated the amortization of goodwill entirely. Instead of amortizing the goodwill on their balance sheets over a multi-decade period, companies are now required to annually test it for impairment. In plain English, this means that they have to examine, on an annual basis, any corporate assets that they’ve acquired, and make sure that those assets are still reasonably worth the prices paid. If they conclude that the assets are not worth the prices paid, then they have to write down their goodwill. The requirement for annual impairment testing doesn’t just apply to goodwill, it applies to all intangible assets, and, per FAS 144 (issued a couple months later), all long-lived assets.”
While FAS 142 may have introduced a more accurate accounting method, it also created an inconsistency in earnings measurements. Present values end up looking much more expensive relative to past values than they actually are. And the difference is quite dramatic. Adjusting for the accounting change would put the CAPE 10 about 4 points lower.
Another reason not to rely on the long-term historical mean of the Shiller CAPE 10 as a yardstick is that far fewer companies pay dividends now than in the past. For example, in their 2001 study, “Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?”, Eugene Fama and Kenneth French found that the firms paying cash dividends fell from 67% in 1978 to 21% in 1999. This has resulted in the dividend payout ratio on the S&P 500 dropping from an average of 52% from 1954-1995 to just 34% from 1995-2015.