No, stocks aren’t wildly overvalued: Citi strategist finds hole in Shiller’s CAPE
There's a lot of data out there that both bulls and bears cite to support their market views. Unfortunately, many of these oft-cited data points aren't subject to real statistical analysis, according to Tobias Levkovich, chief U.S. equity strategist at Citigroup.
In the accompanying video, Levkovich discusses some of these "mythical data" with Lauren Lyster, including the VIX, which he calls "horribly misunderstood."
While the conventional wisdom holds that an unusually low VIX is a sign of dangerous times ahead, i.e. a lack of fear means traders are too complacent, Citi’s analysis of the data shows a VIX in the low teens is actually a fairly bullish indicator. The real 'danger zone' is a VIX in the 20-30 range, whether it's rising or falling, Levkovich says. (Whether the VIX is an accurate measure of market fear is a separate discussion.)
More importantly, the strategist believes Robert Shiller's cyclically adjusted P/E ratio (CAPE) is a flawed indicator mainly because it doesn't "normalize" interest rates as it does earnings.
"It's great to normalize earnings to get a P/E but there's also something called the time value of money," he says. "You will pay very different present values depending upon what the discount rate is: At 1%, 5% or 10% you would have very different outcomes on that P/E as well."
To normalize for rates, Levkovich uses 5-year first swap rates on the 10-year Treasury yield. His modified CAPE shows stocks are below average valuations today, rather than dangerously overvalued as many market bears have (loudly) declared. At current levels, the market has a 91% probability of being up 12 months from today, according to Levkovich.
At a recent Citigroup press briefing, I asked Levkovich about what his rate-adjusted CAPE predicts for stocks 10-years hence, which is the “real” takeaway of Shiller’s cyclically adjusted P/E. His answer, essentially, is that “nobody really invests with a 10-year time horizon anymore,” at least not professional investors who risk losing investors if they underperform for an extended period. In other words, while Shiller may be right about valuations predicting poor long-term results for stocks from current valuation levels, institutional investors can’t afford to think much beyond the next 6-to-12 months, which Levkovich’s work shows should bring continued upside for stocks.
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