James Montier: What Worries Me Right Now - By Robert Huebscher 

The attacks on the CAPE are kind of odd, right? It hasn’t done a bad job. It works. A large part of me says, “Well, if it’s not broken, why the hell are you trying to fix it?” People say, “Well, valuations haven’t mean-reverted for the last 20 years.” My response is, “No, but returns, frankly, have been very poor for the last 20 years.” So there is no inconsistency between a high valuation and low returns.

I think Siegel’s main point is that goodwill accounting misses half of the data. Yes, goodwill accounting has certainly increased the volatility of earnings. But also we had a situation during the crisis, somewhere around March 2009, almost exactly at the bottom, when the accounting authorities suspended FASB rule 157, which was the mark-to-market rule.

All of a sudden, financial institutions could lie with impunity. They no longer had to recognize any of the impact of asset deterioration on their earnings. One can make an equal case on the other side that earnings probably recovered too fast because of that suspension of the rule. That may have created a rather weird pattern. Maybe those two patterns offset, and therefore that is one of the reasons you should take a 10-year average, as the CAPE methodology employs.

The idea of replacing S&P earnings with NIPA earnings is slightly surreal. The S&P is a relatively small number of stocks, whereas NIPA effectively represents very much the entire economy. So the two constituents are very different.

NIPA profits are at extreme highs right now, as are listed-market profits. Basing an evaluation on something that is at an all-time high is almost certainly going to make things look cheaper. To me, this is a strange way of honestly adjusting a valuation measure. I have not yet seen any evidence that the NIPA-adjusted series gives a better return forecast over time than the straight Shiller. That would have to be the hurdle. The burden of proof is on those who think the Shiller model is somehow not useful.

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The issue is, as you quite rightly point out, everything is expensive right now. How do you build a portfolio that recognizes the fact that cash is generating negative returns, and bonds are now more attractive than they were, but still not enticing in any great sense?

The answer is, you have to recognize that this is the purgatory of low returns. This is the environment within which we operate. As much as wish it could be different, the reality is it isn’t, so you have to build a portfolio up that tries to make sense. That means owning some equities where you think you’re getting at least some degree of reasonable compensation for owning them, and then basically trying to create a perfect dry-powder asset.

The perfect dry-powder asset would have three characteristics: it would give you liquidity, protect you against inflation and it might generate a little bit of return.

Right now, of course, there is nothing that generates all three of those characteristics. So you have to try and build one in a in a synthetic fashion, which means holding some cash for its liquidity benefits. It means owning something like TIPS, which are priced considerably more attractively than cash, to generate inflation protection. Then, you must think about the areas to add a little bit of value to generate an above-cash return: selected forms of credit or possibly equity-spread trades, but nothing too risky.

You don’t want to be caught reaching for yield.