In a very thoughtful blog
on the Shiller CAPE, Philosophical Economics notes the following:
“Unfortunately, the earnings data on Dr. Shiller’s website, which are used to build the Shiller CAPE, are not based on a consistent definition of 'earnings' across time. The data are taken from S&P 'reported' earnings, which are formulated in accordance with Generally Accepted Accounting Principles (GAAP). But the standards of GAAP have changed dramatically over the last 15 years.”
The blog then goes on to spend considerable time looking at the impact of FAS 142 and how recent changes in goodwill accounting have dramatically changed reported earnings. The blog concludes that “any comparison between the present value of the [Shiller CAPE] metric and pre-2001 values is a comparison between inconsistently measured data points.”
While I appreciate Philosophical Economics' point, I would offer that the entire 132-year span of Shiller’s calculation is filled with dramatic changes in accounting. At its core, accounting is a regulation, and like all regulations, it follows changes in social mood.
In doing research for Moods and Markets: A New Way to Invest in Good Times and in Bad,
I found, not surprisingly, that when confidence is high, accounting policies become more liberal. When mood falls, they become more conservative. And this is not at all a recent phenomenon. For example, the aftermath of the 1929 stock market crash brought with it a huge conservative swing in accounting policies and procedures along with the foundation for the “standardized” accounting we know today.
But I think it is also worth considering how changes in confidence also alter management estimates – a huge and frequently overlooked aspect of corporate earnings. As confidence rises, forecasts improve. In addition, rigor declines. Scrutiny and confidence are inversely correlated. I offer the following in Moods and Markets
“In bull markets with their rising mood, the net result is that you have increasingly optimistic managers applying increasingly optimistic accounting rules while generating higher and higher levels of earnings that get less and less scrutiny and higher multiples by investors…But appreciate the other side of the peak in mood. In bear markets, investors more closely scrutinize lower earnings, which are determined more conservatively by management applying more conservative accounting rules. At the same time, thanks to lower mood, investors then value those more conservatively prepared earnings less, resulting in lower P/E multiples as well.”
Finally, I would not discount how mood-driven changes in accounting also impact management behaviors. I saw this firsthand over my career in banking as new, high-confidence-driven accounting rules for securitization, derivative, and mark-to-market investing “incented” financial institutions to alter their business strategies. Philosophical Economics suggests that FAS 142 has been punitive, but I’d offer that the 2001 rule that eliminated amortization was an extraordinarily high-confidence accounting-policy change founded on the peak-of-the market belief that massive goodwill write-downs would be the very rare exception, not the norm.
But consider how FAS 142 has changed corporate management behaviors. Rather than building businesses through organic growth – which would reduce current earnings due to increased investment expense – big corporations have largely adopted a growth-by-acquisition strategy. Business leaders have taken full advantage of the “asymmetry” mentioned by Philosophical Economics. For CEOs, if an acquisition goes well, they are heroes. If it fails, the massive goodwill write-down is the next CEO’s problem. Besides, when the write-down does come, it can even be explained away to investors as a non-cash charge that puts past mistakes behind them.
To me, it has been no surprise that the major goodwill write-downs we have seen since the implementation of FAS 142 have come at major bottoms in the markets/confidence – 2002-2003 for the peak of the dot-com bubble deals and 2009-2013 for the oversized 2007 Goldilocks-era deals. (The span of 2009-2013 reflects the different bottoms in confidence for commodity companies versus financial institutions and other industries.)
Needless to say, if we continue to see mega-goodwill write-downs, I fully expect that FAS 142 will be replaced by a much more conservative alternative, much like securitization accounting was reformed in 2010, just after the banking crisis. The FASB, like all policymakers, will once again follow changes in mood.
So do all of the accounting changes eliminate the usefulness or accuracy of the Shiller CAPE?
I don’t believe so at all. The major peaks all reflect “the increasingly optimistic managers applying increasingly optimistic accounting rules while generating higher and higher levels of earnings that get less and less scrutiny” phenomenon I described above, while bottoms clearly show the reverse. And with a current 25 multiple, I’d offer that with the exception of the financial services industry, the former conditions clearly apply today.
Accounting rules are not engraved in stone on tablets laid down by Moses.They are a mood-driven phenomenon. So, too, are markets. Tossing aside a 132-year measure of confidence hardly seems appropriate to me. Still, that a blog as wise as Philosophical Economics is suggesting that investors do just that -- particularly at this point in the economic cycle -- should not be discounted. At tops and bottoms there is a collective view that the old rules somehow no longer apply.
To me it feels like this could be one of those times.
Peter Atwater's groundbreaking book "Moods and Markets" is now available on Amazon and Barnes & Noble.
“Peter Atwater brilliantly provides a framework for understanding both the socioeconomic hubris that led to the great credit bubble of the past decade and the dark social-psychological hangover that has resulted from its collapse. In so doing, he offers an invaluable guide to what promises to be a very difficult and turbulent period ahead as we experience what he calls the ‘me, here, and now’ behavioral tendencies of the post-crash world.” —Sherle R. Schwenninger, Director, Economic Growth Program, New America Foundation
Position in SH and JPM
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