Monday, November 04, 2013
You really can time the stock market
The CAPE has been popularized by Yale University finance professor Robert Shiller, most notably in his book “Irrational Exuberance,” in which he predicted the bear market which began in 2000. It is popularly known as the Shiller PE ratio. It helped him just win the Nobel Prize for Economics. A summary of some of his research is available here.
This metric compares the current prices of stocks, not to this year’s or last year’s per-share earnings, but to the average per-share earnings of the past 10 years (adjusted for inflation). The argument for using this measure is that it smooths out short-term booms and slumps in profits. By this measure, the S&P 500 index has historically been on an average valuation of about 16 times cyclically-adjusted earnings. When share prices have fallen a long way below that level they have proven to be a really good deal over time: Investors who got in when stocks were cheap and hung on made super returns. On the other hand, when the CAPE or Shiller PE has been much above 16, the stock market has been a much less good deal. The subsequent returns have usually been mediocre or worse.
For example a recent analysis by Mebane Faber of Cambria Investments found that, from 1881 to 2011, if you had invested in the stock market when the CAPE was below 5 — a very rare occurrence — you would have earned a spectacular 22% a year over the next five years, even after accounting for inflation. You’d become rich.
If you had invested when the CAPE was between 5 and 10, you’d have earned on average 13% a year.
On the other hand, if you had invested when the CAPE was over 20 you would have earned just 5% a year, and if you had invested when it was over 25 you would have lost money, after accounting for inflation.