The Crux of the Worriers' Fallacy
It is no coincidence that the dire warning signs of professor Robert Shiller’s cyclically adjusted PE (CAPE) have been a false alarm for the past five years and counting, as you point out in “Worriers (Usually) Get Market Wrong.” (WSJ, Nov 20, 2017) As its name implies, cyclically adjusted PE is useful for analyzing valuations of cyclical companies. The assumption: Whatever goes up must come back down. Earnings today, however, are rising more sustainably than in the past.
Social media, internet marketing, online retailing, and online media companies are not cyclical. Facebook, Google, Amazon, and Netflix carry little-to-no inventory, the culprit for past cyclical swings, and are protected by some of the most powerful network effects in corporate history. Apple, with the largest market capitalization, has lower inventory days than almost any other company, a legacy of Tim Cook as COO. Amazon keeps payables greater than receivables plus inventory. As these types of companies increasingly dominate indexes, CAPE becomes less applicable.
A more appropriate way to value a market consisting of companies that grow earnings sustainably is Peter Lynch’s rule that stock-price appreciation should track earnings improvement. On that basis, today’s stock market valuation is not unreasonable. The S&P 500 including dividends is up 16% this year on a 12% increase in earnings per share. Forward PE is only 18X forward earnings, about where it has been for the past 5 years. Today’s stock market calls for Peter Lynch, not Professor Shiller. As earnings go up, so should the stock market. This is 2017, not 1999.