Tuesday, February 25, 2014

GMO white paper: A CAPE Crusader: A Defence Against the Dark Arts - by James Montier

Having spent a large proportion of my career prior to joining GMO working at investment banks, I’m well aware of what Andrew Smithers describes as “Stock Broker Economics,” the second tenet of which is “The market is always cheap.” Over the years I’ve witnessed many attempts by the practitioners of this most dark art to justify why tried and tested measures of valuation are no longer meaningful, or occasionally create new measures of valuation that purport to show the market to be cheap.

A recent outbreak of precisely this brand of sorcery has surrounded the Shiller P/E (price relative to 10­-year moving average earnings adjusted for inflation as shown in Exhibit 1). Wizards range from the seemingly ever optimistic Jeremy Siegel to any number of Wall Street strategists, and even a blogger whose work I generally enjoy. Given that one should always look for evidence that may prove one wrong, I’ve spent some time thinking about the issues they have raised and have summarized my thoughts in this short paper.