By Jeremy Schwartz, CFA, Global Head of Research
Last week’s Behind the Markets podcast featured a conversation with Thomas Phillips, adjunct professor in the Department of Finance and Risk Engineering at NYU’s Tandon School of Engineering, and Adam Kobor, a director of investments at NYU’s Investment Office.
They are co-authors of a paper that caught our attention earlier this year called “Ultra-Simple Shiller’s CAPE: How One Year’s Data Can Predict Equity Market Returns Better Than Ten.”
One feature of the cyclically adjusted price-to-earnings measure Shiller created was to use a 10-year average of earnings to smooth the business cycle, along with an inflation adjustment, to arrive at a more normalized earnings measurement.
The paper by Kobor and Phillips tries a novel approach to smooth earnings by dropping the worst quarter in a given year and normalizing (multiplying by four-thirds) the remaining three quarters as one way to get cyclically adjusted earnings that do not rely on looking back at 10 years of earnings.
Kabor and Phillips point out that during the financial crisis in 2009, the majority of losses were in one quarter, and in 2020’s downturn, the first quarter was far below the other three quarters and gives a more realistic adjustment for normalized earnings during this pandemic.
In addition to smoothing earnings using this one-year approach, their model also incorporates a price-to-sales ratio data point in addition to a price-to-earnings gauge. Given the trends over the last 20 years of profit margins moving higher and earnings growing faster than GDP, the price-to-sales component of the model gives a more pessimistic reading for the future.
The net outlook from the model is for returns to be around 1.5%, with a 3% outlook implied from the earnings metric and negative returns implied by the price-to-sales component. There was some discussion about whether the forces of market competition will ultimately pressure profit margins for some of the large-cap technology names like Facebook and Amazon. Phillips concluded that this CAPE model valuation work would be supportive for value strategies over growth strategies going forward, given the dispersion in valuation multiples.
There are risks involved with investing, including possible loss of principal. Foreign investing involves currency, political and economic risk. Funds focusing on a single country, sector and/or funds that emphasize investments in smaller companies may experience greater price volatility. Investments in emerging markets, currency, fixed income and alternative investments include additional risks. Please see prospectus for discussion of risks.
Past performance is not indicative of future results. This material contains the opinions of the author, which are subject to change, and should not be considered or interpreted as a recommendation to participate in any particular trading strategy, or deemed to be an offer or sale of any investment product and it should not be relied on as such. There is no guarantee that any strategies discussed will work under all market conditions. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This material should not be relied upon as research or investment advice regarding any security in particular. The user of this information assumes the entire risk of any use made of the information provided herein. Neither WisdomTree nor its affiliates, nor Foreside Fund Services, LLC, or its affiliates provide tax or legal advice. Investors seeking tax or legal advice should consult their tax or legal advisor. Unless expressly stated otherwise the opinions, interpretations or findings expressed herein do not necessarily represent the views of WisdomTree or any of its affiliates.