PE RATIO MEAN REVERSION
By Karl Arnold Belser
11 July 2014



Robert Shiller's CAPE (the Cyclically Adjusted Price-to-Earnings ratio) is a way of representing the average return of broad equity markets. His data extends back a couple of hundred years. I observe that this period includes the industrial revolution. The GWP (Gross World Product) grew at about 3 percent from about 1750 until recently. Prior to 1750  the the  GWP grew little if at all.

Shiller showed that a high CAPE value statistically  predicts low returns whereas a low value statistically predicts high returns.
Next Shiller observed that the CAPE varied around a mean value, which value he assumed to be an experimental measure of fair market price.  Hence, one might expect the CAPE to have Mean Reversion. The CAPE then could be used as a prediction tool   leading people to prefer companies or markets with a low PE ratio.

Today (2014) the CAPE in the US seems high and some pundits, like Meb Faber  at a Google financial talk, are stating that the equity market in the US is expensive and that one should look for foreign markets that have a lower CAPE. I question this type of logic.

I consider The Miracle of Compound Growth and Mean Reversion to be fundamental to economic analysis. There are two assumptions regarding growth rate and average investment returns in the above analysis. One is that the world economy will continue to grow at about 3 percent annually and the other is that companies can make the high profit margins corresponding to the mean PE ratio value over the recent past history.
I ask the rhetorical question:

Has the mean for CAPE changed because we have entered into an era, like that before 1750, in which global growth will be slow?


Maybe the high CAPE is indicating that we are going to be experiencing a low return on human activity for a long time to come. That is, the mean value has changed as Tyler Cowen describes in his book The Great Stagnation; How America Ate The Low-Hanging Fruit of Modern History ... .

The book argues that the American economy has reached a historical technological plateau and the factors which drove economic growth for most of America's history are mostly spent. These figurative "low-hanging fruit" from the title include the cultivation of much free, previously unused land; the application and spread of technological breakthroughs, particularly during the period 1880–1940, including transport, refrigeration, electricity, mass communications, and sanitation; and the education of large numbers of smart people who previously received none. - Wikipedia

Cowen points out the the core issue is that many people in the US think that the nation is richer than it really is. Hence we have moved from producing to rent seeking:

rent-seeking is spending wealth on political lobbying to increase one's share of existing wealth without creating wealth. The effects of rent-seeking are reduced economic efficiency through poor allocation of resources, reduced wealth creation, lost government revenue, increased income inequality, and national decline. - Wikipedia

Many of my BLOG entries discuss in some detail different facets of the  changes that are occurring.

My take away from this discussion is that I probably should not consider high PE shares (over 20) as overpriced.  I have been systematically selling such shares. This may prove to be a mistake if the world really is entering a steady state economy.
   
Last updated July 11, 2014
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