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John McMillen | Portfolio Manager

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Searching for the Holy Grail of Investing

February 2015

CAPE Fear: Can we use Valuation Ratios to Time the Market?

With popular market benchmarks like the S&P 500 setting record highs in 2014, many investors have become apprehensive. They’re afraid that a major market decline is imminent and are eager to find a strategy that promises to avoid the pain of an extended downturn while still capturing any up-side potential.

And yet, like the Holy Grail, that “perfect” strategy remains elusive.

But one approach that has attracted considerable attention in recent years is adjusting investments based on the CAPE ratio–the Cyclically Adjusted Price / Earnings ratio.

The CAPE ratio, developed by Robert Shiller of Yale University and John Campbell of Harvard University, seeks to provide a road map of stock market valuation by comparing current prices to average inflation-adjusted earnings over the previous 10 years.1 The idea is to smooth out the peaks and valleys of the business cycle and arrive at a more stable measure of corporate earning power. Shiller suggests that investors can improve their portfolio performance relative to a static equity allocation by overweighting stocks during periods of low valuation and underweighting stocks during periods of high valuation.

A CAPE-based strategy has the virtue of using clearly defined quantitative measures rather than vague assessments of investor exuberance or despair. From January 1926 through December 2013, the CAPE ratio has ranged from a low of 5.57 in June 1932 to 44.20 in December 1999, with an average of 17.54.

Using the CAPE ratio might appear to offer a sensible way to improve portfolio results by periodically adjusting equity exposure, and many financial writers have focused on this methodology in recent years. As an example, a timing newsletter publisher in early 2014 observed, “For the S&P 500, this ratio currently exceeds 25.6, which is higher than what prevailed at 29 of the 35 tops since 1900.”2

Many investors find such an approach very appealing. Does it work?

The challenge of profiting from CAPE measures or any other quantitative indicator is to come up with a trading rule to identify the correct time to underweight or overweight stocks. It is not enough to know that stocks are above or below their long-run average valuation. How far above average should the indicator be before investors should reduce equity exposure? And at what point will stocks be sufficiently undervalued to warrant buying again…Below average? Average?  Slightly above average?

This implementation challenge appears to be the Achilles’ heel of timing-based strategies. A study in 2013 by professors at the London Business School applied CAPE ratios to time market entry and exit points. “Sadly,” they concluded, “we learn far less from valuation ratios about how to make profits in the future than about how we might have profited in the past.”3

As an example of the potential difficulty, consider the CAPE data as of year-end 1996. The CAPE ratio stood at 27.72, 82% above its long-run average of 15.23 at that point. Federal Reserve Chairman Alan Greenspan had delivered his much-discussed “irrational exuberance” speech just three weeks earlier. The last time the CAPE ratio had flirted with this number was October 1929; the CAPE was at 28.96 as stock prices were about to head over the cliff. It seems plausible that followers of the CAPE strategy would have been easily persuaded that investing at year-end 1996 would be a painful experience.

The actual result was more cheerful. The next three years were especially rewarding, with total return of over 107% for the S&P 500 Index. For the period January 1997–June 2014, the annualized return for the S&P 500 Index was 7.67%; modestly below stocks’ long-run average, but still a strongly positive equity premium.

By comparison, a timing strategy over the same period of being fully invested in stocks only during periods when the CAPE ratio was below its long-run average produced an annualized return of 3.09%.

All timing strategies face a fundamental problem: Since markets have generally gone up more often than they have gone down in the last 90 years, avoiding losses in a down market runs the risk of avoiding even heftier gains associated with an up market.

And yet, a successful timing strategy remains the holy grail of the investment world. For decades, Wall Street firms and individual investors have spent countless hours and expended tremendous financial resources in the quest for “It”, only to realize that “It” doesn’t exist.  Using the CAPE ratio to time the buying and selling of stocks is simply another expedition that will lead to a disappointing outcome.

Searching for the key to outwitting other investors may be fun for those with a sense of adventure and lots of time on their hands. For those seeking the highest probability of a successful investment experience, maintaining a consistent allocation strategy is likely to be the sounder choice.

1. CAPE data available at  http://www.econ.yale.edu/~shiller/data.htm; 2. Mark Hulbert, “This Bull Market is Starting to Look Long in the Tooth,” Wall Street Journal, January 18, 2014; 3. John Authers, “Clash of the CAPE Crusaders,” Financial Times, September 3, 2013. Adapted from “CAPE Fear: Valuation Ratios and Market Timing” by Weston Wellington, Down to the Wire column on Dimensional’s website, September 2014. Dimensional Fund Advisors LP ("Dimensional") is an investment advisor registered with the Securities and Exchange Commission. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This content is provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement
of any particular security, products, or services. 

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