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What The Failure Of Shiller’s CAPE Shows About Stock Picking

Summary Empirical models are validated based on predictive success, not backtesting. CAPE has been above average 98% of the time since introduction in 1988, and thus never worked. CAPE has failed because earnings have secularly risen since 1992. Capital deployed on corporate buybacks and acquisitions has hit record levels during this time. Capital spent on hiring and expansion increases competition and wages. Conversely, financial engineering favors restrained hiring and improved margins. When major technology companies are compared, it is often the efficiency of capital allocation that is more important than the initial strength of their moat. Above Average is the New Average The New York Times , Marketwatch , the Wall Street Journal , and some Seeking Alpha articles all periodically warn that, according to “the historical best predictor”, stocks are currently overvalued. To be sure, SA offers a diversity of viewpoints, whereas the NYT publishes any opinion which is Robert Shiller’s. This putative best predictor is, of course, Shiller’s Cyclically Adjusted Price/Earning (CAPE) ratio, namely the current price of the S&P 500 divided by a moving 10-year earnings average, adjusted for inflation. Mr. Shiller first advocated this measure in 1988 . The idea seems so sensible it has been widely embraced, despite frequent complaints that CAPE has recently broken down. CAPE has not broken down. It has never worked. Since it was introduced, CAPE has spent about 98% of the time above average . The situation is reminiscent of Garrison Keilor’s Lake Woebegon, “where all children are above average.” We now have close to three decades of reasonably strong stock gains, despite a nearly incessant prediction that stocks are overvalued. Even CAPE’s rare dip below “average” was hardly impressive: following the Great Recession crash, CAPE in 2009 briefly suggested that stocks were 15% undervalued. Gains since then have been about 20% (annualized, not a one-time rise). Proper Empirical Model Testing But doesn’t Shiller’s model still deserve to be called the best historical predictor, given the century or so of data leading up to the 1990s? No. An empirical model is constructed using one set of data (“construction set”), and tested using a new set of data (“test set”). An empirical model should not even be announced if it does not work on the data used to construct it. Shiller’s model was announced in 1988, and constructed using S&P 500 data up to that date. Valid testing is based on subsequent years. Since introduction, it has almost continuously warned that it was not a good time to be in stocks. Yet stock gains over the last quarter century have been quite satisfactory. Yes, CAPE was particularly high before the crash in 2000, but even the ordinary trailing-twelve-month P/E was above 40. One does not need binoculars to see a barn by daylight. With quibbling exceptions, CAPE has been stuck on sell since construction. Even a stopped clock will eventually be right. CAPE is Not High Because of Irrational Investors The theory has not failed because of irrational exuberance lasting more than two decades. Jeremy Siegel has argued that CAPE should be higher than the average imputed from older data because improvements in accounting standards have upgraded the quality of earnings. Whether that is really true or not (Mr. Shiller disagrees), it is not the reason CAPE has failed. The answer – at least the proximate answer – is straightforward. Earnings since 1992 have not been cyclical at all, as the graph below shows. They have secularly increased. (click to enlarge) In addition to the secular earnings uptrend since about 1992, one should note that the decrease in earnings during the 2008-2009 Great Recession can be compared only to the early 1920s. Using CAPE today means assuming that a once-in-a-century event will happen again soon. Incidentally, CAPE is not ideally constructed. Because only aggregate earnings are considered, a company can actually negatively contribute to the valuation of the whole S&P 500. If you own 9 stocks with positive earnings, and I give you one more with negative earnings, the value of your portfolio has not declined. CAPE ought to have been constructed with positive definite components. If that mathematical term is unfamiliar, it simply means no company should negatively contribute to the value of the index. The problem is not hypothetical, given AIG’s losses reached $61.7B in a single quarter in 2008. The uptrend since the early 1990s has been quite strong, as noted in a thoughtful post from Philosophical Economics : “Over the last two decades, the S&P 500 has seen very high real EPS growth-6% annualized from 1992 until today. For perspective, the average annual real EPS growth over the prior century, from 1871 to 1992, was only 1%.” If earnings are rising by 6% a year, then predicting future earnings by a trailing 10-year average does not work . Concrete Example: CAPE Prediction vs Reality A concrete example should help demonstrate that CAPE has been high not because investors have continuously overpaid (for a quarter century!), but because CAPE has been too pessimistic about profits. The CAPE debate has been going on long enough to provide this handy example from four years ago : … CAPE was reported as 23.35 during the month of July 2011 on the Irrational Exuberance website ( irrationalexuberance.com ). Per an analysis frequently used in practice, comparing the July 2011 CAPE to its long-term average of 16.41 indicates that U.S. stocks are currently overvalued by 42.3%. In contrast, on July 22, 2011, Standard & Poor ‘ s reported a price-earnings ratio of 16.17. Using round numbers, stocks had a 100% gain over the 4 years since that warning, only about a quarter of which was P/E inflation. CAPE has almost continuously under-predicted future profits since its introduction. Why the Secular Rise in Earnings? Profit margins have surged to a record 10% of GDP, from historical values of about half that. One does not have to look too hard to discover what companies have been doing differently. When companies have excess capital, they can (1) invest in developing new products, (2) expand existing operations, or (3) buy stock, either their own or acquiring another company. In other words, they can increase competition, or engage in “financial engineering.” It is no secret that share buybacks have hit record levels, actually accounting for the majority of the total cash flow for S&P 500 companies. That is unprecedented. Mergers and acquisitions are also going briskly, with the WSJ reporting September 17 that $3.2 trillion has been spent so far this year (the number is worldwide, but the U.S. still certainly participating full heartedly in this orgy). Note that the Shiller CAPE method does capture the direct effect of share buybacks on increasing earnings. The “P” is market cap, and the share buybacks increase earnings per share, but do not change total company earnings (or, necessarily, total market cap). However, financial engineering has salutary secondary effects not captured by CAPE. Consider the case of Apple (NASDAQ: AAPL ) toward the end of the Jobs era, when Apple was sitting on $100B in cash. Steve Jobs asked Warren Buffett what should be done with the money. Mr. Buffett suggested share buybacks. This answer did not satisfy Mr. Jobs, but it has worked for Tim Cook, and Apple shareholders. Suppose that instead Apple had decided to introduce its own television (as Gene Munster incorrectly insisted), sell its own car, design its own CPU for notebooks and desktops, and perhaps even do its own fabrication of processors, instead of paying Samsung ( OTC:SSNLF ). One hundred billion is enough to do all these things at once. Each of these would have required new hiring, and building new plants. All that hiring would have tended to drive up wages. Also, the increased competition would have driven down prices, or at least had a tendency in that direction. In short, when companies buy back stock, or better yet, buy each other, instead of spending the money to increase competition, wages are kept down, and profit margins are higher. Who Benefits? While companies have spent preferentially to reduce competition (acquisitions), or by buying their own stock, rather than by hiring people to expand operations, wages have not kept up with economic growth. In fact, while corporate profits hit a record percentage, wages have increased only slowly since the end of the Great Recession. For someone hoping to be hired, or anyone wishing that another company would bid up his salary, financial engineering might not seem quite so salutary. From the viewpoint of shareholders, the recent fiscal discipline of companies such as Apple is commendable. Any specific product from any specific company might be a better idea than share buybacks. But for the market in the aggregate, less competition, lower wages, and higher profit margins have been a winning formula. Capital Allocation Some company CEOs are empire builders, others prize efficiency. Efficient allocation of capital can cause some investors’ eyes to glaze, whereas heavy spending on long shots can be inspirational. It is surprising how many people I’ve encountered, who are more likely to buy Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ) because it is working on driverless cars, investigating quantum computing, and frittering away money needlessly indulging the founder’s whims. Conversely, Wall Street money managers take capital allocation quite seriously. The enormous surge Google had in the hours after its July earnings report had little to do with the actual mediocre results and a great deal to do with hints that the recently hired CFO, Ruth Porat, was going to bring much-needed efficient use of capital to the company. Anticipating a Counter Example Microsoft (NASDAQ: MSFT ) pays dividends and buys back shares. Amazon (NASDAQ: AMZN ) spends everything it earns from its retail operations to compete in new areas. It also has been hiring robustly to do so. Doesn’t this show that financial engineering doesn’t work? Hardly. MSFT practiced laughably poor capital allocation for at least two decades. Say the words “serial overpayer” to a market aficionado and she will likely take you to mean MSFT. MSFT also tried to emulate the great laboratories of the past (such as Bell Labs of the old AT&T (NYSE: T ), or what Xerox (NYSE: XRX ) had), hiring notable academics for long-range research. And MSFT has spent tens of billions trying in vain to compete with Google in search and Apple in phones. Amazon gave the last one a go as well. But when the Fire Phone failed, it didn’t spend another $7.2B to buy a fading phone designer. Amazon just laid off the associated workers from its Lab 126. The company is not worried about this quarter’s numbers, but the company is nonetheless very results-oriented. Bezos was a hedge fund manager before founding Amazon, and his keen interest in careful capital allocation manifests in many ways, including not overspending on employee benefits, and the practicality of the projects Amazon attempts. Admittedly, a stock buyback is rarely the absolute best possible use of money. It is, however, typically better than the empire building most CEOs attempt. Summary Part 1: So, Is The Market Overvalued? One generally can do well by simply looking at ordinary (meaning TTM) P/E, and whether that has been rising or falling. The current P/E is 20 and, alas, trailing-twelve-month earnings have been falling for about a year. Forward analyst estimates are meaningless, as documented in excruciating detail in Burton Markiel’s A Random Walk Down Wall Street . So, yes, stocks are overvalued, but by about 15-20%, versus the 40% plus suggested by the current CAPE (= 25). Believing in CAPE requires believing a once-in-a-century profit recession is imminent, and that corporations are soon going to abjure financial engineering and start more aggressive expansions – plausible, but hardly certain. Summary Part 2: Capital Allocation In The Aggregate For the market as a whole, the current large portion of corporate free cash flow spent on share buybacks and acquisitions has restrained hiring and thus wage pressure, while reducing competition. This has steadily improved net profit margins, and raised corporate profits to a record 10% of GDP. This phenomenon largely explains why profits have not been cyclic, but secularly rising. Summary Part 3: Capital Allocation In Stock Picking For the very long-term investor seeking to exploit the tax advantages of unrealized gains, capital allocation is crucial. Indeed, because of compounding, capital allocation will eventually win out. If a company fritters away its earnings, even a business as great as Microsoft’s can struggle to provide adequate returns. Conversely, if a company returns money to shareholders, and carefully monitors whether its projects are producing worthwhile results, long-term performance will be superior. Disclosure: I am/we are long AMZN. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Fed-Free Week Still Full Of Obstacles For ETFs

Summary A 2015 rate hike is off the table. In the near term, USDU might be the preferred option of the pair simply because it is short several emerging markets currencies, which have the potential to continue falling. As is often the case with weekly ETF previews, some familiar ETFs frequently re-emerge, and that is the case this week. By Todd Shriber, ETF Professor After a week spent worshiping at the altar of the Federal Reserve, financial markets will be spared the specter of a Fed meeting in the week ahead. However, that does not mean a 2015 rate hike is off the table. San Francisco Fed President John Williams told reporters last week that a rate hike this year could be appropriate. Richmond Federal Reserve President Jeffrey Lacker on Saturday said he dissented at a Fed policy meeting because he thought the economy was now strong enough to warrant higher interest rates, Reuters reported . Federal Reserve Bank of St. Louis President James Bullard said he argued against the continuation of the Fed’s zero interest rate policy. The ETF Situation The PowerShares DB USD Bull ETF (NYSEARCA: UUP ) and the actively managed WisdomTree Bloomberg U.S. Dollar Bullish ETF (NYSEARCA: USDU ) are the two primary exchange traded funds tracking greenback fluctuations, so suffice to say these ETFs would like 2015 rate hike momentum to reemerge and do so soon. In the near term, USDU might be the preferred option of the pair simply because it is short several emerging markets currencies, which have the potential to continue falling. UUP tracks the dollar against major developed market currencies, some of which could and should rally the longer the Fed puts off higher interest rates. There is some evidence to suggest some market participants were not reassured by the Fed’s no-hike call last week. For example, the Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ) and the Utilities Select Sector SPDR ETF (NYSEARCA: XLU ) , each among the most rate-sensitive sector ETFs, lost a combined $382.3 million in assets last week. XLP posted a modest gain, while XLU climbed 1.6 percent – which could mean the latter is worth monitoring in the week ahead. Watch List As is often the case with weekly ETF previews, some familiar ETFs frequently re-emerge, and that is the case this week. It should be noted the Global X FTSE Greece 20 ETF (NYSEARCA: GREK ) merits a place on traders’ watch lists in the week ahead. In what feels like a monthly occurrence, Greece holds national elections again this weekend. Even with potential for increased volatility due to the election and news of a major index provider lowering Greece’s market classification , the Global X FTSE Greece 20 ETF climbed 3.8 percent last week and is up 6.3 percent over the past month. It could be a sign of a renewed risk appetite, though only time will tell, but the PowerShares QQQ Trust ETF (NASDAQ: QQQ ) , the NASDAQ-100 tracking ETF, hauled in over $1.2 billion in new assets last week despite suffering a modest drop. Remember what investors are doing by being long QQQ. They are making an ETF proxy bet on the likes of Apple, Microsoft and Amazon, as those stocks combine for over a quarter of QQQ’s weight. Disclaimer: Neither Benzinga nor its staff recommend that you buy, sell, or hold any security. We do not offer investment advice, personalized or otherwise. Benzinga recommends that you conduct your own due diligence and consult a certified financial professional for personalized advice about your financial situation. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

XLY: Do You Need More Aggressive Allocations?

Summary XLY offers investors a fairly aggressive portfolio that is more volatile than the market but benefits from diversification. Most of the allocations seem very reasonable, but MCD looks like a fairly conservative option. If an investor is going to buy into this aggressive fund, they should have a rebalancing plan in place. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. One of the funds that I’m reviewing is the Consumer Discretionary Select Sector SPDR ETF (NYSEARCA: XLY ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so the goal is to design portfolios that perform well on a risk adjusted basis, not portfolios that necessarily beat the market. Expense Ratio The expense ratio for XLY is .15%. That isn’t too bad. I’m usually expecting to see high expense ratios that drain away the investor’s money, but XLY scores well in this regard. Largest Holdings (click to enlarge) The top of the holdings for XLY is Amazon (NASDAQ: AMZN ). For investors seeking to find companies trading at low fundamentals such as P/E ratios, Amazon’s history of not turning a meaningful profit may be a concern. While earnings are a concern for Amazon, sales have been an area of strength as the company blossomed over the last 15 years and has become a household name. The difficulty for this portfolio is the reliance on discretionary spending. This is a reason for the portfolio to show some substantial volatility when investors are concerned about another recession and falling personal expenditures. The interesting holding here is McDonald’s (NYSE: MCD ) coming in as the 5th holding. I would not put MCD in the same category as the other top holdings. MCD pays a very strong dividend, has a long history of doing so, and in a bad economy the restaurant can pick up new customers that are trading down to buy McDonald’s products rather than more expensive food. The rest of the top 10 holdings are all companies that I would expect to perform best when consumers are readily disposing of income. Building the Portfolio This hypothetical portfolio has a fairly aggressive allocation for the middle aged investor. Only 25% of the total portfolio value is placed in bonds and a fifth of that bond allocation is given to high yield bonds. If the investor wants to treat an investment in an mREIT index as an investment in the underlying bonds that the individual mREITs hold, then the total bond allocation would be 35%. Given how substantially mREITs can deviate from book value, I’d rather consider the allocation as an equity position designed to create a very high yield. This portfolio is probably taking on more risk than would be appropriate for many retiring investors since a major recession could still hit this pretty hard. If the investor wanted to modify the portfolio to be more appropriate for retirement, the first place to start would be increasing the bond exposure at the cost of equity. However, the diversification within the portfolio is fairly solid. Long term treasuries work nicely with major market indexes and I’ve designed this hypothetical portfolio without putting in the allocation I normally would for equity REITs. An allocation is created for the mortgage REITs, which can offer some fairly nice diversification relative to the rest of the portfolio and they are a major source of yield in this hypothetical portfolio. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. Because a substantial portion of the yield from this portfolio comes from REITs and interest, I would favor this portfolio as a tax exempt strategy even if the investor was frequently rebalancing by adding new capital. The portfolio allocations can be seen below along with the dividend yields from each investment. Name Ticker Portfolio Weight Yield SPDR S&P 500 Trust ETF SPY 35.00% 2.06% Consumer Discretionary Select Sector SPDR ETF XLY 10.00% 1.36% First Trust Consumer Staples AlphaDEX ETF FXG 10.00% 1.60% Vanguard FTSE Emerging Markets ETF VWO 5.00% 3.17% First Trust Utilities AlphaDEX ETF FXU 5.00% 3.77% SPDR Barclays Capital Short Term High Yield Bond ETF SJNK 5.00% 5.45% PowerShares 1-30 Laddered Treasury Portfolio ETF PLW 20.00% 2.22% iShares Mortgage Real Estate Capped ETF REM 10.00% 14.45% Portfolio 100.00% 3.53% The next chart shows the annualized volatility and beta of the portfolio since April of 2012. (click to enlarge) A quick rundown of the portfolio Using SJNK offers investors better yields from using short term exposure to credit sensitive debt. The yield on this is fairly nice and due to the short duration of the securities the volatility isn’t too bad. PLW on the other hand does have some material volatility, but a negative correlation to other investments allows it to reduce the total risk of the portfolio. FXG is used to make the portfolio overweight on consumer staples with a goal of providing more stability to the equity portion of the portfolio. FXU is used to create a small utility allocation for the portfolio to give it a higher dividend yield and help it produce more income. I find the utility sector often has some desirable risk characteristics that make it worth at least considering for an overweight representation in a portfolio. VWO is simply there to provide more diversification from being an international equity portfolio. While giving investors exposure to emerging markets, it is also offering a very solid dividend yield that enhances the overall income level from the portfolio. XLY offers investors higher expected returns in a solid economy at the cost of higher risk. Using it as more than a small weighting would result in too much risk for the portfolio, but as a small weighting the diversification it offers relative to the core holding of SPY is eliminating most of the additional risk. REM is primarily there to offer a substantial increase in the dividend yield which is otherwise not very strong. The mREIT sector can be subject to some pretty harsh movements and dividends from mREITs should not be the core source of income for an investor. However, they can be used to enhance the level of dividend income while investors wait for their other equity investments to increase dividends over the coming decades. If you want a really quick version to refer back to, I put together the following chart that really simplifies the role of each investment: Name Ticker Role in Portfolio SPDR S&P 500 Trust ETF SPY Core of Portfolio Consumer Discretionary Select Sector SPDR ETF XLY Enhance Expected Returned First Trust Consumer Staples AlphaDEX ETF FXG Reduce Beta of Portfolio Vanguard FTSE Emerging Markets ETF VWO Exposure to Foreign Markets First Trust Utilities AlphaDEX ETF FXU Enhance Dividends, Lower Portfolio Risk SPDR Barclays Capital Short Term High Yield Bond ETF SJNK Low Volatility with over 5% Yield PowerShares 1-30 Laddered Treasury Portfolio ETF PLW Negative Beta Reduces Portfolio Risk iShares Mortgage Real Estate Capped ETF REM Enhance Current Income Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. Despite TLT being fairly volatile and tying SPY for the second highest volatility in the portfolio, it actually produces a negative risk contribution because it has a negative correlation with most of the portfolio. It is important to recognize that the “risk” on an investment needs to be considered in the context of the entire portfolio. To make it easier to analyze how risky each holding would be in the context of the portfolio, I have most of these holdings weighted at a simple 10%. Because of TLT’s heavy negative correlation, it receives a weighting of 20% and as the core of the portfolio SPY was weighted as 50%. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio. Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. (click to enlarge) Conclusion XLY offers investors a fairly aggressive allocation that is heavy on companies that should succeed when the market is doing well and should struggle more during a market downturn. To take advantage of the investment investors would want to be ready to buy into the ETF when fear is stronger in the economy. In my opinion, the most effective way to do that would be to set up an automatic rebalancing schedule or use allocation bands and buy in/sell off whenever the allocation was exceeding the desired range. Due to some diversification benefits, a small allocation can be used in a portfolio without driving up the total risk of the portfolio. However, investors aiming to use the ETF for more than 10% or so of the portfolio may find their volatility across the portfolio increasing. An investor could counteract some of that additional risk by increasing their allocation to treasury securities with an ETF like PLW where the correlation between the two funds is a negative .4. Despite a fairly low expense ratio, if an investor is using a large enough portfolio they may still find it worthwhile to imitate the portfolio by buying up the major holdings because so much of the portfolio is held in the top 10. For the investor that wants to get a little more aggressive without a large enough portfolio to replicate XLY, it looks like a fairly solid option for the sector. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.