We received a question today regarding the usefulness of the Shiller P/E. For starters, it has a wonderful long-term history. There aren’t many series where we have 130 years of history.
Using the Shiller P/E makes us ask ourselves a very simple
question when we attempt to value stocks: are current earnings a good
representation of the long-term earnings capacity of stocks?
That forces us to consider the prevailing level of profit
margins. Today they are quite a bit above the long-term average, and
historically that has been a good leading indicator for negative profit growth. If there is any mean reverting tendency to margins, the
current level of profit margins suggest annual earnings growth of -10% for the
next 4 years.
To be precise, current profit margins—using the latest NIPA
data—are 57% above the long-term average.
So, what got margins to these levels to begin with, and what
could that tell us about the projected future path?
Let’s start with the idea that margins are a form of savings
(for the corporate sector), similar to the household savings rate (for
household sector) or budget deficit (savings, or dis-savings as is the case,
for the government sector). Savings in one sector has its reflection in
the savings or dis-savings of the other sectors. So, when we think about
margins, we are thinking about the interplay between the savings of these three
sectors.
Savings by the corporate sector has a reflection in the
savings of the household sector and government sector. For the decade
prior to 2001, it was fairly normal for the combined savings of the household
sector and government sector (household savings rate + budget deficit as a % of
GDP) to run around +5%. In this environment margins trended between 5-7%.
Beginning in 2001, the sum of government and household
savings began to decline. Both the household sector and government sector
reduced their savings rates, down to the point that the combined sum was zero
in the years leading up to the financial crisis. In this environment,
profit margins (corporate savings) drifted up to over 8%. So, margins
achieved record heights as the combined sum of the private and government
sector was zero.
As the financial crisis took hold and government sector
enacted a set of policies to further dis-save, the combined household and
government savings rate fell to almost -5% of GDP. In this backdrop,
margins surged to levels never seen in post war history.
The combined sum of household and government savings has
just crossed back over the zero threshold, offering us a great insight into the
likely course of margins in the years to come.
We can probably take for granted continued reductions in the
budget deficit in the years to come, so it all comes down to the
consumer. If the household sector chooses to run down its savings rate in
the years to come, margins probably hold pretty firm. If the household
sector instead chooses to hold or increase its savings rate, then it seems
quite likely margins will face a headwind. The future course of
taxes will probably figure into households decision.
Margins have already contracted for five quarters (as budget
deficits shrink), with margins having peaked in the fourth quarter of 2011.
So, going back to our original question of whether current
earnings are a good representation of long-term earnings capacity, my answer is
“not likely”. The last few years are a pretty unique period in history,
with record household+government dis-saving reflected as record profit margins.
If we margin adjust the Shiller P/E incorporating profit
margins that are 57% above the long-term average, we calculate a P/E of around
33.5x. To put this in historic context, at the peak of the tech
bubble in 2000, we hit 40x earnings on this metrics, and in 2007 we hit 35.5x. At the low in 1982, as margins were below average, we hit
5.8x. If the post WW2 average Shiller P/E is just under 19x, we
are around 80% above that level currently.
We think in the end, the key to the Shiller P/E is how it
used. It is an invaluable tool that helps us ask the right
questions.
