Calculating CAPE
Headlines
One of our models is a “calculating CAPE” from macroeconomic fundamentals approach. The model did a magnificent job of highlighting the “tech wreck” overvaluation, and likely did so again in the current inflationary environment.
Detail
We are taking a cyclically adjusted price earnings ratio, and trying to forecast its intrinsic or fundamental value based on macroeconomic inputs.
We know that under certain assumptions, an earnings yield can be expressed as a real risk free rate, plus a risk premium minus an estimate for earnings growth.
Here, we use CBO’s potential output growth YoY as a proxy, and use the natural rate of interest (r*) as the long run real rate input.
You’ll note we also show inflation, I’ll come to that in a moment.
Economic theory suggests there is a relationship between the interest rate and growth, and we can model that below using a 3rd order polynomial (detail doesn’t matter).
Given a long run view on potential output growth, we can then model the long run r* over time.
We are now ready to predict our intrinsic or fundamental CAPE value. Note the below statistically significant correlates – right sign, right magnitude.
Why does inflation appear? Aren’t CAPE’s adjusted for inflation in both denominator and numerator? Why does the impact of inflation still clearly comes through?
It is because analysts often mark up the rising interest rate, in their models, easily enough, but not the revenues that go with them (causing stocks to be undervalued, often, in high inflation environments) and mark down the declining interest rate, in their models, easily enough, but not the revenues that go with them (causing stocks to be overvalued, often, in low inflation environments).
That’s what the regressions detect.
The net result was a Shiller PE that once again looked crazy overvalued relative to market, a clear DAA market timing device.
Of course it is just one model, and we didn’t expect persistent inflation in the first place, but if you had, this is exactly the model you would weight more heavily, in your process.
As it was, we were some 600bps UW equities, at the DAA level, in our direct equity portfolios, and some 400bps UW fixed income, in a moderately defensive position ahead of the now famous “Fed hawkish pivot” of November last year.
Important Information: This document has been prepared by Aequitas Investment Partners ABN 92 644 165 266 (“Aequitas”, “our”, “we”), a Corporate Authorised Representative (no. 1284389) of C2 Financial Services, (Australian Financial Services Licensee no. 502171), and is for distribution within Australia to wholesale clients and financial advisers only.
This document is based on information available at the time of publishing, information which we believe is correct and any opinions, conclusions or forecasts are reasonably held or made as at the time of its compilation, but no warranty is made as to its accuracy, reliability or completeness. To the extent permitted by law, neither Aequitas nor any of its affiliates accept liability to any person for loss or damage arising from the use of the information herein.
Please note that past performance is not a reliable indicator of future performance.
General Advice Warning: This document has been prepared without taking into account your objectives, financial situation or needs, and therefore you should consider its appropriateness, having regard to your objectives, financial situation and needs. Before making any decision about whether to acquire a financial product, you should obtain and read the relevant Product Disclosure Statement (PDS) or Investor Directed Portfolio Service Guide (IDPS Guide) and consider talking to a financial adviser.
Taxation warning: Any taxation considerations are general and based on present taxation laws and may be subject to change. Aequitas is not a registered tax (financial) adviser under the Tax Agent Services Act 2009 and investors should seek tax advice from a registered tax agent or a registered tax (financial) adviser if they intend to rely on this information to satisfy the liabilities or obligations or claim entitlements that arise, or could arise, under a taxation law.