Comment: CAPE crusaders may not save the day

Clear signs that the mighty US economy has overcome the weather-related setbacks earlier this year sent both the Standard & Poor’s 500 and the Dow Jones Industrial Average to record highs last week. The Dow closed above 17,000 for the first time as positive US economic news helped bolster investor confidence in America and globally.

Bill Jamieson. Picture: Ian Rutherford

The buoyant mood was helped by a statement from Janet Yellen, chairwoman of the US Federal Reserve, that there was no need yet for America to raise interest rates to allay concerns about overheating.

The FTSE 100 Index ended the week 1.6 per cent higher at 6,866, while the Eurofirst 300 Index gained 1.7 per cent.

New highs for the world’s biggest stock market spark two powerful reactions. The first is to bolster confidence among millions of investors that their nest eggs are benefiting from rising markets, encouraging many to step up their investments. There’s nothing like a rising market to draw in more money from households.

But it also causes more seasoned investors to worry whether we might be at or near a market top, particularly as this bull run has continued for five years. So it is no surprise that last week’s fresh upward surge caused some to reach for traditional measures of stock market value to see if shares might now be vulnerable to a downturn.

Two analytical tools are commonly cited. One is the ubiquitous price-earnings ratio or P/E, calculated by using net income over the most recent 12-month period and dividing this by the weighted average number of shares in issue. A “forward P/E” uses estimated net earnings over next 12 months.

A high price-earnings multiple can act as an amber light for investors, signalling that a share has become overly valued when compared to its peers; a low P/E is often cited as a validation of value or relative cheapness.

But a high P/E can also be seen as a sign of earnings quality and often attaches to successful companies or those considered to have outstanding growth prospects. A low P/E can be a warning sign about low earnings and poor prospects. So the P/E ratio needs to be read with care.

And it can be a fickle guide as to when a share becomes over-valued or liable to correction.

Lars Kreckel, equity strategist at Legal & General Investment Management, cautioned against relying on valuation measures for market timing decisions.

He said: “Multiples are great at predicting long-term equity returns. Unfortunately, most investors aren’t focused on ten-year returns, but more on a one-year horizon, or sometimes shorter. As soon as the time horizon is shortened, the predictive power of multiples diminishes considerably.” P/E ratios, he added, provided no correlation with returns over 12 months.

And investing in a stock with a low valuation does not protect investors against losses – Russian energy giant Gazprom, trading on a P/E of two times before the Ukraine crisis hit the Russian stock market, “fell no more or no less than any other Russian stock,” Kreckel said.

A more sophisticated variant is the cyclically adjusted price-earnings ratio or CAPE. It represents the price of a stock divided by the ten-year average of reported earnings per share, both adjusted for inflation. It provides a better guide to the fluctuating value of a stock throughout business cycles.

Shares today do not look cheap on this measure. Using the S&P 500, the current CAPE valuation is about 25.6 times earnings, well above its long-term average of 16.5 times (though well shy of the giddy highs of the technology bubble). The forward P/E is standing at 15.6 times, just under the average since 1989.

And it is still not too helpful in guiding investors on the timing of their investment decisions. Craig said: “Using the Cape as a guide, investors should have exited the market a couple of years ago and would have missed out on the significant returns of 2012 and 2013.”

Snapshot of saving

An OFT-repeated concern in recent years has been the difficulty experienced by young people in saving anything out of their stretched budgets. This has fuelled concerns about a massive pensions gap in the years ahead.

But new research out last week revealed a rather more encouraging picture. It found more than five million aged between 18-24 are saving regularly each month – £204 on average – and have managed to put away on average £3,200 each.

A Disposable Income Index from insurance concern and ISA provider Scottish Friendly revealed that young savers are putting aside £204 on average each month and that more than half (55 per cent) have no set reason as to why they are saving, – but 44 per cent also admit to relying on the Bank of Mum and Dad to help them when their money runs out. Surprising and familiar in equal measure.