Much, much has been written lately about CAPE and whether or not it can be useful. Back in 2009-10, bears were using it to demonstrate the folly of getting back into equities. Today, because CAPE remains in dangerously high territory, bulls are dismissing it or are trying to find ways to explain why it has not worked in the past 5 years to justify leaving it in the cupboard. The last times I wrote on CAPE were in Nov. 2012 (The Shiller P/E: Alas, A Useless Friend) and in Feb. 2014 (“LEAVING CAPE TOWN”).

Jeff, a reader, sent me a link to yet another attempt at modifying CAPE to render it more useful. Tom McClellan, a technical analyst who publishes The McClellan Market Report wrote an article about a modified CAPE which was reproduced by Pragmatic Capitalism under the title A Scary Valuation Indicator. I am not a CAPE fan for reasons amply detailed in my above mentioned posts but this latest attempt got me working: rarely have I seen people incorporate historical interest rates in their P/E analysis, even though it is inherently part of the P/E DNA. Could this latest version be the one that would provide CAPE with its missing ingredient?

Tom McClellan explains the relationship in layman’s terms:

This is because the P/E ratio is the inverse of the “earnings yield”, which should reasonably match up with bond yields. If an investor can get a better return on his money in the bond market, then he will flee the stock market, or vice versa. That is what keeps the earnings yield and bond yields in correlation. But when investors are bidding up stock prices to a ridiculous point such that the earnings yield is way out of whack from the bond interest yield, then there can be a big problem.

The idea is that by dividing the actual CAPE multiple by the Moody’s Baa bond yield, one would get a P/E ratio adjusted for credit risks as embedded in the Baa yield. McClellan makes no serious attempt at fundamentally justifying the relationship, other than to see that

(…) the result seems to set a much more uniform ceiling for how high valuations can go.

Not bad. A CAPE ratio divided by Baa yields at or above 5 has indeed identified most market peaks. It missed the 2008 peak but maybe the high bar should be set at 4.5 rather than 5.0.

The buy signals are not so obvious however, and the usefulness of the ratio between 1970 and 1995 left a lot to be desired.

What McClellan fails to see is that the real interest in this modification of CAPE is in the indirect incorporation of inflation in the equity valuation approach, something missing in virtually all valuation methods other than the Rule of 20.

Absolute P/E ratios are of little usefulness in assessing equity valuations as this chart reveals. Simply knowing that P/E ratios tend to fluctuate between 10 and 20 is an important but still often useless information. (Click on charts to enlarge)

Inflation is a crucial factor influencing earnings multiples. Saying P/E ratios are historically low or high without looking at inflation is like commenting on the weather looking through a window without knowing if it is cold or warm outside. Incomplete information may be hazardous to your physical or financial health.

The Rule of 20 P/E is simply the sum of the actual P/E on trailing earnings and the inflation rate. The next chart shows the much more stable (read useful) pattern compared with the actual P/E. The Rule of 20 P/E fluctuated between 15 and 25 with very few exceptions over the past 60 years. For investors, the Rule of 20 P/E provides a vital reading of how current equity markets really compare with their historical valuation range, using only actual data. Why nobody cares about this extraordinary relationship while desperately trying to make use of the CAPE P/E keeps eluding me.

Back to the Baa yields into CAPE. Below, I charted the modified CAPE with the Rule of 20 P/E (divided by 6 to have it on the same scale). The superiority of the Rule of 20 is obvious.

Looking at the current valuation readings, the Rule of 20 P/E is sitting at the “20” level, the border between lower and higher risk markets. The modified CAPE, like the original, is at extreme valuation levels, where it has been for the last 2 years. In addition to the original CAPE flaws, the modified version incorporates its own flaw: in effect, we can easily argue that the current interest rate structure is significantly impacted by the various interventions by the Fed and the ECB in recent years. As such, Baa yields are arbitrarily low at the present time and do not reflect credit risks and/or inflation premium in a manner consistent with history.

To conclude, here’s the Rule of 20 Barometer since 1956 (se also Understanding The Rule Of 20 Equity Valuation Barometer). You should also take a look at THREE-STARRED EQUITIES