18th October 2013

Analytical investors are always keen to invest at the right moment on a particular stock; they would look at the price earnings ratio – a common metric for valuing companies. A low P/E suggests that a stock is relatively cheap and a high one suggests it is overpriced.

Avid market participants prefer what is called the “Shiller P/E Ratio” named after Nobel laureate and Yale University Professor Robert Shiller. The Shiller P/E is also known as the cyclically adjusted price earnings ratio (CAPE) – it is calculated by taking the S&P 500 and dividing it by the average of ten years worth of earnings. If the ratio is above the long term average of 16, the stock market is considered expensive. Robert Shiller, author of “Irrational Exhuberance” who predicted the dot com and housing bubbles says the CAPE is remarkably good at predicting returns over the period of several years. CAPE stands for cyclically adjusted price earnings ratio and is constructed to smooth out corporate earnings cycles to determine if stocks are cheap or expensive- the ratio is calculated by dividing the S&P 500’s current price by the index’s average real reported earnings over the last ten years. By comparing a company’s multiple year P/E ratios to its historical average, the investor can try to decide whether the shares of a particular company are cheap without being misled by short term blips. The 10 year period is the most favoured timescale, though some people work with 3 year or 5 year histories, when doing this each year number is calculated using the previous ten years, so the end result is a moving average.

The Shiller P/E is a more reasonable market evaluation indicator than the P/E ratio because it eliminates fluctuation of the ratio caused by the variation of profit margins during business cycles. The Standard & Poor’s 500 trailing P/E now stands at 16.87, above its long term historic average of roughly 15.5. The Shiller P/E for the S&P 500, on the other hand, is 23.2. That is, 40.6 percent higher than its historic mean of 16.5, even after the recent sell off and suggests limited upside for equities going forward.

CAPE inflated by biased earnings?

Jeremy Siegel, Professor of Finance at the Wharton University says the predictions from the CAPE ratio are bearish, in an article that appeared in FT he said “all but nine months in the past 22 years the Cape ratio has been above it long term average”, and the ratio currently predicts well below average returns. He says that the claims of “bears” who say that the current earnings are unsustainably high is not true, the earnings of U.S stocks which have risen to more than 150 percent are unlikely to fall and higher P/E ratios may propel stocks even higher. Prof. Sieger says that the CAPE ratio is based on “biased earnings data”- he explains that the changes in accounting standards in the 1990’s, forced the 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. For example: AIG wrote down $ 80 billion which Siegel believes will skew the S&P P/E  ratio for the next 10 years. This change in earnings pattern is evident when comparing the cyclical behaviour of S&P 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 over valuation. Prof Siegel calls the Cape “the single best forecaster of long-term future stock returns”. But he says the data on which it is based are now unreliable, sending out a false signal that stocks are expensive. Prof Siegel recently told CNBC that the Dow could hit 17,000 this year.

Both academicians have enthusiastic backers: Prof Shiller is defended by market bears while Prof Siegel has been embraced by the bulls.

The post Jeremy Siegel Says CAPE Ratio Has a Big Bias appeared first on International Finance.

10th October 2013

At a time where women are taking over coveted positions in corporates and other sectors, the banking sector is no exception. Marisa Drew, Credit Suisse Group AG (CSGN)’s most senior female investment banker in Europe, expects it will take at least five years before women start to gain a greater share of senior positions in the industry. As per a report from Bloomberg and data inputs from Egon Zehnder International – women make up 19 percent of European bank boards, compared with 33 percent in the household’s products industry, which has the highest level of female representation. The world now has many influential leaders such as Angela Merkel- the German Chancellor known for her deft handling of the Euro crisis, Christine Lagarde – Managing Director of the IMF since 2011, U.S. Secretary of State –Hillary Clinton and Brazilian President- Dilma Rouseff who has been ranked as the third most powerful woman in the world by Forbes magazine. Adding to the list was Fiona Wolf, a partner of the law firm CMS Cameron McKenna LLP, who was named as the 686^th Lord Mayor of London, only the second woman chosen to head the financial district’s municipal government in 800 years.

Now, adding to the list is the deeply experienced, imaginative and technically adept economist – Janet Yellen who will be the named next chair of Fed, succeeding Ben Bernanke whose term ends in January 2014. Yellen, 67, presently the vice-chairwoman of the Board of Governors of the Federal Reserve System will be the first woman to head the central bank in its 100 year old history. The Fed is the most powerful bank in the world and any action or changes in its policy is known to impact financial markets and emerging economies immensely. Janet Yellen won the race after Obama’s trusted lieutenant Larry Summers withdrew from the candidature after being opposed in the Senate for his close affiliations in the Wall Street. Yellen was appointed as vice chair in October 2010, she was President and CEO of the Federal Reserve Bank of San Francisco from 2004 and 2010 and also served as chair of the Council of Economic Advisors from 1997 to 1999. Prior to joining the Fed, Yellen spent much of her time as a professor at the University of California at Berkeley, where she had been teaching since 1980.

Path Ahead

A close proponent of the Q.E, she has been a key architect of the Fed’s efforts under Bernanke to keep interest rates near record lows to support the economy. These include the Fed’s monthly bond purchases and its guidance to investors about the likely direction of rates. “I commend President Obama on his selection of Dr. Yellen to be the first woman to serve as Federal Reserve Chairman,” said Senate Banking Committee Chairman Tim Johnson, in a statement late Tuesday. “She has a depth of experience a second to none and I have no doubt she will be an excellent Federal Reserve Chairman” he said. The current vice-chairwoman of the Board of Governors of the Federal Reserve System is married to Nobel Prize winning economist George Akerlof, whom she met in 1977, when they were economists at the Fed board- they married the following June and left the Fed to teach at the London School of Economics, their only son is also an economics professor in a renowned university.

Bernanke’s term ends in January 2014, completing an eight year tenure in which he helped pull the U.S. economy from its worst financial crisis since the 1930’s. Bernanke has led the Fed with some unconventional policies which have seen the economy recover, businesses prosper, lowering unemployment figures and credited for saving the U.S. banking system.

Unemployment Vs Inflation

Yellen, a distinguished economist subscribes to the Philipps-Curve-Model that trades off unemployment and inflation. In other words, rather than excess money creation as the cause of raising prices (which imbalances the economy), she focuses on the unemployment rate, the volume of new jobs being created and the growth of the overall economy. Lawrence Kudlow, an American economist who writes for various U.S. newspapers wrote on his blog that “If the Fed supplies more cash than the markets want, the inflation rate can go up whether unemployment is high or low. America has experienced this in the 1970’s when high inflation was accompanied by high unemployment” Kudlow, who is a proponent of supply side economics further elaborated “ The Fed is going to encounter excruciatingly difficult problems as it deals with withdrawing its Q.E-3, markets should be the guideposts for these decisions, not the unemployment rates” he says. “She is a very able economist; he concedes but warns “if you work from the wrong money model, you are likely to get the wrong money results”. However, Nathan Sheets, former head of the Fed’s division of International Finance said “Janet Yellen would be a vigorous proponent of the dual mandate. “The quest to appropriately balance the legs of the dual mandate, in the face of a disappointing recovery, is the primary challenge that Yellen would face” as Fed chairman.

But, Yellen strongly backs her theory of to stabilize output and boost employment when capitalism fails, a views she strongly favours and shaped by late Nobel laureate James Tobin at Yale University in New Haven, Connecticut, where she obtained her P.hd Degree in Economics. Yellen, who began her career as a “staff economist” in 1977 in the Fed’s division of International Affairs has profound knowledge in labour economics- she along with her husband George Akerlof  have co-authored more than a dozen papers that delved into the mechanics of how people switch jobs and what it means when workers perceive their wages as unfair.

Our View

Known as a “dovish” policy maker in the Wall Street, a person who is more permissive on inflation and tilted towards boosting employment, she is the most deserving candidate to the Fed’s chair. Apart from her academic experience, she has more than a dozen years in the Fed as a policy maker, in her speeches she frequently refers to model and simulations showing her expertise to deal rationally in difficult scenarios. The appointment of Yellen who will continue Q.E- is also a welcome move to emerging nations particularly – Brazil, Indonesia and India whose national currencies have plummeted due to Fed decision to taper its bond purchases.

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