Don’t put faith in Cape crusaders

US stocks have risen more than 150 per cent from their bear market low, and many are asking whether they are overvalued. The S&P 500 Index is selling for between 15 and 16 times 2013 estimated earnings, close to its historical average. The bears claim that current earnings are unsustainably high and can be expected to fall. Bulls, including myself, believe earnings are unlikely to fall and higher price-to earnings (P/E) ratios may propel stocks even higher.

Important support for the bear camp comes from the cyclically adjusted price/earnings (Cape) ratio, developed by Robert Shiller of Yale University, which computes the P/E ratio on the average of the past 10 years of earnings. Its purpose is to smooth out temporary fluctuations in profits caused by business cycles.

The Cape ratio has been a powerful predictor of long-term equity returns, forecasting strong returns in the early 1980s and poor returns from the market peak in 2000. But for many years its predictions have been very bearish. In fact, in all but nine months in the past 22 years the Cape ratio has been above its long-term average, and the ratio currently predicts well below-average stock returns.

I believe the Cape ratio’s overly pessimistic predictions are based on biased earnings data. Changes in the accounting standards in the 1990s forced companies to charge large write-offs when assets they hold fall in price, but when assets rise in price they do not boost earnings unless the asset is sold. This change in earnings patterns is evident when comparing the cyclical behaviour of Standard and Poor’s earnings series with the after-tax profit series published in the National Income and Product Accounts (NIPA).

For the 2001-02 and 2007-09 recessions, S&P reported earnings dropped precipitously due to a few companies with huge write-offs, while NIPA earnings were more stable. Yet before 2000, the cyclical behaviour of the two series was similar. Downward biased S&P earnings send average 10-year earnings down and bias the Cape ratio upward. In fact, when NIPA profits are substituted for S&P reported earnings in the Cape model, the current market shows no overvaluation.

A second argument used by bears is that the profit margins (the ratio of earnings to sales) of US companies are at unsustainably high levels and are likely to fall. Indeed, in 2012 profit margins of S&P 500 companies (based on operating income) reached 8.9 per cent, well above the long-term average of 7.2 per cent.

But David Bianco, chief equity strategist at Deutsche Bank, has shown that most of the margin expansion over the past 15 years has come from two factors: the increased proportion of foreign profits, which have higher margins because of lower corporate tax rates; and the increased weight of the technology sector in the S&P 500 index, a sector that usually carries the highest profit margins.

Higher profit margins also result from stronger balance sheets. The Federal Reserve reports that since 1996, the ratio of corporate liquid assets to short-term liabilities has nearly doubled, and the proportion of credit market debt that is long term has increased to almost 80 per cent from about 50 per cent. This means many companies have locked in the recent record low interest rates and will be much less sensitive to any future increase in rates, keeping margins high.

The bullish case for equities relies not only on the expectations of higher earnings but also on the possibility that P/E ratios will expand significantly. It is a historical fact that low inflation and low interest rates translates into higher P/E ratios.

Since 1954, whenever long-term interest rates have been below 8 per cent, the P/E ratio of the S&P 500 Index has averaged 19. Real interest rates (and hence yields on inflation-linked Treasury bonds) are strongly tied to GDP growth and if the “new normal” growth pessimists are right, real interest rates are unlikely to rise above 2 per cent. Even if inflation runs somewhat above the Fed’s 2 per cent target, nominal rates on Treasury bonds will rise to at most the 5 per cent level, below the zone where P/E ratios contract.

Long-term real returns on stocks are strongly linked to their “earnings yield”, which is the reciprocal of the P/E ratio. It is not a coincidence that the historical average P/E ratio for stocks of 15 yields an earnings yield of 6.7 per cent, extremely close to the 6.6 per cent historical real return for stocks.

If the P/E ratio rises to 20, that produces a 5 per cent forward-looking real return for stock investors that would still give stocks a 3 per cent edge over bonds. That difference, called the “equity premium”, is right in line with its historical average. If the price-earnings multiple expands, as I believe is very likely, this bull market is still far from its peak.

Jeremy J. Siegel is the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania