Just use common sense

The other day there was an interesting article in the FT, entitled clash of the Cape crusaders. Professor Robert Shiller and Professor Jeremy Siegel, both leading market historians, have different views on investing and current equity valuations. Professor Shiller has developed a method of valuing stocks he calls Cape. Cape stands for cyclically adjusted price earnings. His methodology is not to take a snap shot of one year's earnings, but to take an average of company's earnings over a 10-year period and then adjust those earnings for inflation. Professor Shiller believes that this method provides a better picture of how a company performs over the economic cycle, and therefore one can get a better sense of its true valuation. Cape is currently suggesting the US equity market in particular is overvalued.

One of Professor Shiller's claims to fame is that he wrote a book titled, "Irrational Exuberance". He used Cape methodology to warn investors about the Internet bubble. At the time many experienced market practitioners realised that particular bubble had to burst. Common sense told you valuations were losing touch with reality. Professor Shiller is also credited with calling the peak of the housing market in 2007. Professor Siegel on the other hand is an old fashioned "buy and hold" investor, and believes the Cape methodology has its flaws. Professor Siegel's book "stocks for the long run" argues that stocks over the long term have returned on average 6.5% after inflation, and remain attractive today. Professor Siegel did have one hiccup in 2007, announcing that he felt equity markets could rise another 25%. 

To my mind both have historians arguments have their merits. I know many investors who follow Professor Shiller and his Cape. I also know many investors who don't like using price earnings multiples at all, as they believe earnings are too easily manipulated. Buy and hold strategies have proved to be more profitable than those who favour short term trading strategies, but there can be many hiccups along the way. I always find it helpful when investing not to rely on any one method or rational as they all have merits and flaws, but take into account many views, and see what makes the most sense at the time. As I did in 2000, the one thing I always try and apply, common sense, if it looks to good to be true it usually is.

Posted on September 5, 2013 .