Memo to CAPE Slaves
Earlier this year and during much of last year, I’d taken the Cyclically Adjusted Price-Earnings ratio to task for various reasons, most notably the fact that it didn’t allow for accounting changes (GAAP losses are recorded differently), structural changes in our economy (are we all still farmers?), structural changes in the makeup of the stock market (isn’t software inherently more profitable than railroading?), taxation (dividends get preferential treatment versus ordinary income) etc. See Leaving CAPE Town for more.
Long story short, there were a million reasons to ignore the idea that, according to CAPE, the S&P needed to be cut in half. Those in the investment industry who’ve been slavishly loyal to the metric are sitting with a pile of cash and a portfolio full of relentlessly expiring index put options, underperforming everything in sight – be it animal, vegetable or mineral.
One argument that should have gotten more attention as we dismantled the CAPE meme, however, was the fact it almost never tells you to be invested. As Anatole Kaletsky explains at Reuters, waiting for a CAPE buy signal is like waiting for a lucid moment from Courtney Love…
Investors who followed Shiller’s methodology, however, would have missed out on almost all these gains. For the Shiller price-earning ratio showed the stock market to be overvalued 97 percent of the time during these 25 years. Even during the two brief periods when the Shiller ratio was below its long-term average — in early 1990 and from November 2008 to April 2009 — it never sent a clear buy signal.
Instead, Shiller’s approach suggested that the valuations in 1990 and 2009 were only just below fair value — implying there was very limited upside at the beginning of two great bull markets that saw prices multiply fivefold from 1990 to 2000, and threefold from 2009 to 2014 (so far).
Instead, Shiller’s approach suggested that the valuations in 1990 and 2009 were only just below fair value — implying there was very limited upside at the beginning of two great bull markets that saw prices multiply fivefold from 1990 to 2000, and threefold from 2009 to 2014 (so far).
The Shiller ratio’s predictive performance would have been just as bad in earlier decades if it had existed. During the equity bull market of the 1950s and 1960s, for example, the ratio would have said Wall Street was overvalued for 96 percent of the 19-year period stretching from early 1955 to late 1973.
If your preferred valuation methodology keeps you under-invested a majority of the time because of absurd comparisons to past economic eras, it’s garbage. CAPE should be treated like any other single variable, not like an answer in and of itself. Because it doesn’t actually answer anything on its own.
Nothing else does either, so no offense.
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