New Shiller CAPE-Like Model Offers Subdued Outlook

Last week’s Behind the Markets podcast featured a conversation with Thomas Phillips, adjunct professor in the Department of Finance and Risk Engineering at NYU’s Tandon School of Engineering, and Adam Kobor, a director of investments at NYU’s Investment Office. 

They are co-authors of a paper that caught our attention earlier this year called “Ultra-Simple Shiller’s CAPE: How One Year’s Data Can Predict Equity Market Returns Better Than Ten.”

Professor Jeremy Siegel has published on how earnings distortions in GAAP earnings can lead to misguided and overly pessimistic conclusions from the original Shiller CAPE model framework. 

One feature of the cyclically adjusted price-to-earnings measure Shiller created was to use a 10-year average of earnings to smooth the business cycle, along with an inflation adjustment, to arrive at a more normalized earnings measurement. 

The paper by Kobor and Phillips tries a novel approach to smooth earnings by dropping the worst quarter in a given year and normalizing (multiplying by four-thirds) the remaining three quarters as one way to get cyclically adjusted earnings that do not rely on looking back at 10 years of earnings.

Kabor and Phillips point out that during the financial crisis in 2009, the majority of losses were in one quarter, and in 2020’s downturn, the first quarter was far below the other three quarters and gives a more realistic adjustment for normalized earnings during this pandemic.

In addition to smoothing earnings using this one-year approach, their model also incorporates a price-to-sales ratio data point in addition to a price-to-earnings gauge. Given the trends over the last 20 years of profit margins moving higher and earnings growing faster than GDP, the price-to-sales component of the model gives a more pessimistic reading for the future. 

The net outlook from the model is for returns to be around 1.5%, with a 3% outlook implied from the earnings metric and negative returns implied by the price-to-sales component. 

There was some discussion about whether the forces of market competition will ultimately pressure profit margins for some of the large-cap technology names like Facebook and Amazon. Phillips concluded that this CAPE model valuation work would be supportive for value strategies over growth strategies going forward, given the dispersion in valuation multiples.