07/13/2014 Calculating the True CAPE Ratio

Just to add some detail to the logic of my earlier post: I’m using the M1 money supply as a deflator instead of CPI.  The difference shows a relative CAPE ratio shift from the Shiller calculation of 25.96, to a vastly different value of 16.55:

(Source http://www.econ.yale.edu/~shiller/data.htm)

 

The 25.96 value is the one that scares Hussman.

And he would be right to be scared.  But what Hussman isn’t taking into account is that QE skews the value of the CAPE ratio down to a lower value:

 

So far as an expected earnings yield for the next decade, Hussman is seeing 4% annualized returns for the next ten years.  Using M1 as a deflator, the earnings yield is closer to the average of about 6% -- still a little low, but not drastically so.

In other words, the market is not primed for a crash – but instead primed for boredom.

All of this raises the question of what QE was for.  Was it merely to raise prices?

In a word, yes.

But why was it needed?

The answer has to do with the deflationary pressures caused by the demographic pressure of baby boomers hitting retirement age.  In simplest terms, prices rise when demand rises against supply.  Conversely, prices fall when demand falls against supply.

Retiring baby boomers are doing what ALL retiring people do: reducing their demand so that their retirement savings don’t die off before they do.  They don’t want to eat dog food later, so they stop eating lobster now.

Bernanke fought deflation by devaluing the dollar faster than retirees could reduce their own spending.

The Shiller CAPE ratio is based on CPI, which has lagged behind the massive M1 hikes caused by QE.  Inflation WILL come, but not until around 2018 or so, when the demographic pressures bottom out and begin to rise again.

Shiller deserved his Nobel prize, and I don’t want to negate the value of his work.  I’m merely pointing out that his work was never based on the types of distortion created by QE, and when we take QE into account we find the market priced for boring returns, rather than catastrophic losses.

The market HAS risen in real value in the last few years, but not nearly as much as it would appear.  You have to divide the rise in “price” against the total supply of money to get a more realistic picture.

Tim