WWII 062: Robert Schiller CAPE Ratio Explained, Staring at Stock Prices, Gaming your Roth IRA, Housing Demand Exceeds Supply
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Main Topic: The Cyclically Adjusted Price to Earnings Ratio Explained
The Cyclically Adjusted Price-Earnings Ratio was created by Dr. Robert Schiller and is referred to as the CAPE ratio, the Schiller P/E ratio, or the P/E 10 ratio. All mean the same thing.
This ratio was based on work by Benjamin Graham and David Dodd in the classic investment text Security Analysis (which is called the Bible of value-investing because of its heft). They proposed that a company’s earnings should be normalized over five or ten years because one year earnings are too volatile to make investment decisions on.
Then in 1988, Robert Shiller and John Campbell concluded that a “long moving average of real earnings help to forecast future real dividends.”
Over ten years, companies will have experience the business cycle in their industries, and one should be able to calculate a normalized earnings level through the cycle as a basis for a cyclically adjusted valuation.
If you calculate this ratio back to the 19th century for the S&P 500 index, you will find that on average, this ratio is around 16. Not all ten-year periods are equal to one business cycle however, so if you are going to look at the CAPE ratio and attempt to interpret it, there are some things you should know.
First, the average business cycle in the U.S. has been about six years, versus the ten years for the CAPE ratio.
Second, the CAPE uses reported earnings, not operating earnings, which will include one-time write-offs. During periods of falling commodity prices, for example, commodity producers will often have substantial write-downs of the value of their producing properties to comply with generally accepted accounting principals (GAAP), which will impact the CAPE over-all.
Third, the CAPE is adjusted to account for inflation, and the adjustment does not account for ongoing changes in the way the consumer price index (CPI) is calculated, creating an apples to oranges comparison.
Fourth, accounting standards have changed significantly over time, reducing the reliability of earlier earnings figures going way back in time.
All this means is that a high CAPE reading does not necessarily mean a correction is imminent. The market can appear “over-valued” for a long period of time without a correction.
All that being said, today’s reading is about 27 times versus the median of 16. The CAPE reading in the internet bubble in 200 was over 40x, and the financial crisis it was about where it is now.
Personally, I don’t look too much at the CAPE ratio, or use it to decide how to invest. It’s an interesting data point, but not one that is predictive.
Ask JB: How often should I be checking my stocks?
JB Says: I consider long-term much longer than one year. I give an idea one to three years to begin working. My best ideas have taken about five years or so to really work. As a professional, full-time investor, I need to check prices more often than you should, often several times a week. I try to keep that to one day, but I also have dealt with separating my emotions from my investments so I am not subject to the same type of emotional reaction that will cause knee-jerk reactions like panic selling or such things.
If I am accumulating a position, I like the stock to remain near my original entry point or below as I am buying it, but I don’t buy more often than once per week on average. In normal times, I may buy only once a month.
If you are just getting started in investing, you don’t have the time to waste watching prices move up and down. Spend that time learning how to value a company.
submitted an hour ago by Ghoxty
JB Says: It’s always interesting how people try to invent new ways to make their lives more complicated when the old ways are complicated enough. If you over-fund your Roth IRA, you will have to take out the over-funded amount plus any gain you may have received from it. You will then pay short-term tax on the gain, plus a 10% penalty if you are not eligible for withdrawals. Further, the market may not cooperate with you to provide a return at all
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