Jim Rogers made a name for himself with outsized returns in the 1970s with long time friend and partner George Soros. Rogers has been outspokenly bearish on U.S. stocks for years. At a certain price though, things can change.
So at what price would Rogers buy? Rogers was recently quoted in Fortune magazine as saying, "historically, you buy stocks when they're yielding 6% and selling at eight times earnings. You sell them when they're at 22 times earnings and yielding 2%."
So the next question becomes what form of earnings multiple does he look at? Do you look at a period like now, where as-reported S&P 500 earnings are falling because the period we are in is a bust phase? I think the answer is probably not. In a year when times are good and corporations are facing booming profits, PE's look low, while periods where times are tough profits are small and PE's inflate to make things look overpriced.
That's why I think Rogers was using famous finance economist Robert Shiller's method of valuing the stock market. Shiller uses a cyclically adjusted PE ratio that smooths out those earnings over 10 years and adjusts those earnings for inflation. Shiller's book Irrational Exuberance brought into view the psychology of the masses creating massive bubbles in financial markets. The book published in March 2000 came out at the peak of the secular bull market that began over 20 years earlier. Shiller predicted a crash, or at minimum, dismal returns in the stock market. Shiller's website contains an amazing amount of stock market data that shows every month's cyclically adjusted price to earnings ratio since 1881.
In an interview with Henry Blodget recently, Shiller mentioned that although stocks are cheaper than average now with a CAPE of 13, he wouldn't buy until the ratio falls under 10. So I decided to check whether Jim Rogers was right about buying at 8 times earnings and selling at 22. I used Shiller's data to create a fictitious portfolio to buy when the ratio fell under 9 and would wait till the ratio rose from the previous month. I would sell when the ratio went over 22 and then fell from the previous month.
The results are as follows:
- Sell at end of April 1899 with a CAPE of 23.15 and buy at the end of January 1918 with a CAPE of 6.64. The cumulative performance over those 18 years as represented by the Dow Jones was -8% nominally. There were 11 bull and bear markets over that time frame so the market didn't go straight down, just overall weak returns.
- Buy at end of January 1918 with a 6.64 CAPE and sell at end of April 1929 with a CAPE of 27.57. The performance of the Dow Jones over that time frame was roughly 385%. That's an annual performance of 14% over an 11.25 year time frame.
- Sell at end of April 1929 with CAPE at 27.57 and buy at the end of July 1932 with a CAPE of 5.84. Large caps dropped 71.7% during this period with an annualized return of –32.2%. The best performing index since 1926 has been the small cap value sector, that sector fell 81.5% for an annualized return of –40.5%. This was a blistering bear market that surprisingly still had 11 total bull and bear markets in the Dow Jones. A bear market is a 20% decline that was preceded by a 20% rally. A bull market is the opposite, a 20% rise that was preceded by a 20% decline. You didn't sell the ultimate secular bull market top in September 1929 by using my "CAPE method" but you were awfully close, and you did buy one month after the ultimate secular bear market low of 1932.
- Buy at the end of July 1932 with CAPE at 5.84 and sell at the end of March 1937 with a CAPE of 22.04. The cumulative performance for the large caps was 267% and annualized return of 32.2% over a very short time frame. If you bought small cap value stocks you had a 550% return annualized at 49.4%. .
- Sell at the end of March 1937 with a CAPE of 22.04 and buy at the end of June 1942 with a CAPE of 8.91. The large caps lost 36.6% of their value with a –8.3% annualized return over this time frame even though in 1938 the market ended up roughly 32%. Small value lost 48.4% at an annualized return of -11.8%.
- Buy at the end of June 1942 with a CAPE of 8.91 and sell at the end of January 1962 with a CAPE of 21.2. The large caps returned 2042% during this period with a 16.9% annual return. Small value 3124% at an annual return rate of 19.4%.
- Sell at the end of January 1962 with a CAPE of 21.2 and buy at the end of October 1974 with a CAPE of 8.74. The large caps had a total return of 61% with a 3.8% annual return over a 12.75 year time frame. Small value returned 126% over this time frame with a 6.6% rate of return but there were 6 down years in between and you would have done as well in fixed income without the tremendous volatility.
- Buy at the end of October 1974 with a CAPE of 8.74 and sell at the end of August 1995 with a CAPE of 23.28. The large caps returned 1622% with a 14.6% annual return over this period. The small cap value sector returned 5,030% with a 20.8% annual return over this period.
- Sell at the end of August 1995 with a CAPE of 23.28 and buy at the end of ??? The CAPE has not fallen below 9 yet so the secular bear market will continue. The market can rally from here and even have a 2003-2007 run, but until this ratio falls below 9 this will be a traders market, not a buy and hold market. The large caps are up about 78% with a 4.3% annual return from September 1 1995 to April 1 2009 so the data still proves weak returns. The small value sector has had a 212% return at an annualized rate of 8.7%. Many up and down years in between. This is a secular bear market like the 1899-1920 period or the 1962-1975 period that likely won't end until stocks are trading at 8 times earnings or as low as 5 times earnings like in 1932. The reason why I believe that bottoms are made when the CAPE falls below 9 is because CAPE basically tells you the overall average that you can expect for corporations to earn over a business cycle. So a CAPE of 8 would mean you are buying at a price where you get over 12 percent earnings for every dollar invested if the business cycle is normal. When CAPE hovers over 22 you are getting less than 4.5% earnings yield so your future returns should be lower until investors are so despondent that they throw in the towel on investing. At this point, it is the ultimate time to invest and shun timing advice and take a long term view.
Footnote: From 1929-2009 I used the IFA index return calculator
Disclosure: no positions