Financial ratios that just don’t work

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Why some financial ratios should be taken with a pinch of salt…

The start of a new year is normally filled with plenty of optimism for the future as everyone returns to work. This year, however, has started off to a very bumpy start. In the 131-year history of the Australian share market, only five times has the month of January been a final top to a major sell-off: these were in 1901, 1906, 1953, 1973 and most recently, in 2000. We will have wait to see if 2016 will fall into this grouping, or if it is merely a ‘New Year’s Eve hangover’ waiting to be shaken off.

Whenever bad news springs up, financial analysts and journalists cite various financial ratios to demonstrate why the share market or the economy is overvalued. They go on to argue why we will see further downside risk to come, and why we should be fearful for the future.

The reality is there are some really good financial ratios, which you can use as a quick rule of thumb to gauge if the share market is over or undervalued before completing some more detailed analyses. But there are also some really terrible ones, which unfortunately more often than not attract the attention of the press.

The most commonly touted—and possibly the worst—ratio is the CAPE ratio. This stands for the ‘cyclically adjusted price to earning’ ratio. Yes, it has a really fancy name and was largely developed and promoted by Robert Shiller and John Campbell. Shiller was a Nobel prize winner in 2013 for his work on the analysis of asset prices, so he has a loyal following.

The idea of this ratio is that it looks at the long-term moving average of earnings of the market and then adjusts it for inflation in order to forecast future returns. The logic behind this is that it tries to smooth out the short-term volatility of earnings and medium-term business cycles that go with a general economy.

The graph below depicts the 10-year ratio, which was a further refinement of the original work completed by Shiller:

Screen Shot 2016-01-15 at 10.15.24 AM

Now, the medium over the 100 years has been 16.7 and currently, the market is at 25.3. Oh no—does that mean the share market right now is overvalued?

If we assume the graph is accurate, we could interpret this ratio as follows:

  • The last time the share market was ‘fair value’ was 1988. So for the past 27 years, the share market has been overvalued and is just waiting to crash. Gosh, it has been a long wait.
  • Even at the bottom of the ‘tech wreck’ or 2009 GFC lows, the ratio only reached fair value and did not quite get to undervalue levels.
  • The last time this ratio was seriously undervalued was from 1973 to 1987. Yet when the 1987 crash transpired, the graph only shows this ratio as being at fair value levels of the market.

Now, Robert has done some really great work in other areas; equally, he has recently been trying to fine tune his CAPE ratio to get it to actually work, but as you can see, its reliability has been pretty terrible over the past 27 years.

I am not trying to say that the share market is either over or undervalued at present levels; that is an argument for another day. What I am trying to illustrate is there are some wonderfully good, quick ‘rule of thumb’ ratios that you can use to gauge whether the market is over or undervalued, before more detailed analysis is undertaken to confirm this initial observation. There are also some really terrible ratios available. So the next time you read an article that quotes the CAPE ratio, just smile… and move on.

Please also remember that before embarking on any investment decision, you should always seek professional guidance from a licensed financial planner. Of course, I recommend AJ Financial Planning.