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Regular readers know that I am a skeptic when it comes to the Shiller CAPE ratio approach to market valuation. I am delighted to report that I have discovered how to profit handsomely from Prof. Shiller's method. There is nothing like a convert!

Background

I have reviewed the Shiller method on several occasions, usually challenging the assumptions and conclusions.

Initial Complaints

In January of 2011 I explained that while I liked Shiller, I found problems with his method. His forecast was for an S&P 500 at 1430 in 2020. Since I am forecasting Dow 20K, I see this forecast as seriously wrong.

Shiller. I start with a bias. I like professors, I respect Yale, and I am impressed by Professor Shiller -- both his work and his personal appearances. I am therefore surprised that I cannot find more useful advice from his analysis. Here are three key points:

  1. No one has ever made any money in real time by following Shiller, including Shiller. He got out of the market in 1997. I invite comment from anyone who has a track record of successful real-time trading based upon the Shiller method.
  2. Shiller's approach does not successfully predict next year's earnings, the most interesting data for nearly every stock analyst and market forecaster. I have an open challenge to anyone to show that Shiller's backward looking method is better than the one-year forward estimates by analysts at predicting next year's earnings. This is a simple factual challenge with no takers so far.
  3. Shiller's approach almost never signals a buy. Maybe if interest rates get to 20% again we will see the P/E ratios in the single digits that his back testing shows to be a good time to have made a (theoretical) stock purchase.

To summarize: The Shiller method provides no real guidance for investors.

Shiller's Own Advice

Prof. Shiller does not manage investments, nor does he give investment advice. When he gets some good questions, you learn that he does believe in buying stocks, as I noted in this post.

Shiller's Own Advice

A well-staged discussion can provide fresh information. Challenged by Kudlow and Siegel, Shiller stated the following:

  1. A young person with a long time horizon should have a 50% stock allocation. (This is a dramatic deviation from most interpretations of his findings).
  2. The market bottom in 2009 was not really a great time to invest. It was only a little better than average.
  3. If you want to make a big commitment, you should wait for times like 1981. (He did not mention that this would also require a double-digit interest rate).

You can verify all of this by watching the video, especially after the 4 minute mark.

The Profit Margin Question

In May of 2012 I posed a question for Shiller disciples:

My simple question is, "Why does a Shiller disciple care about profit margins?"

If your method only looks at the trailing earnings from the last ten years, and you think that stocks need to decline 30% or so before you would consider buying, then why the interest in profit margins? This only affects current and forward earnings, which have little effect on your metrics.

This would seem to be a question of far greater interest for those who see expected earnings as relevant. Before attempting to answer these questions on a familiar topic, I solicit reader input...

I appreciate the reader response, but it left me still pondering. That is the main reason for the delay in following up. Here is a sampling of the comments:

CMP says:

The reason that "Shiller disciples" care about profit margins is simple: it shows why they are right.

Shiller disciples believe that the 12 month trailing P/E is a bad measure of value and that the reason why it is currently giving a misleading reading is because profit margins are unusually high. When profit margins regress to the mean, then the 12 month P/E will come back in to line with the CAPE, unless the market falls.

It would be extraordinary if Shiller disciples didn't care about profit margins, because the fluctuations in profit margins over time are a key reason that Shiller (plus Ben Graham and others) designed the CAPE in the first place.

Chris of Stumptown says:

I am not sure what constitutes a "Shiller disciple," but I've followed the argument for a while now.

As the name would indicate CAPE does inform on future earnings. That's what "cyclically adjusted" means.

As I see it, the profit margin question is a distinct issue. The current high margin regime has persisted and even grown across multiple cycles. The "disciples" claim that mean reversion always occurs, but they have been saying this for at least a decade.

One reason to care about CAPE might be that it bears a close relation to Q, but they do not provide the same signal at the same time. Given that replacement cost is quite slow to change, CAPE reverts to Q. Andrew Smithers has quite a bit of information on this.

Charles Hinton:

Re profit margins...they reflect interest rates among other things.
Low rates foster higher margins.
Higher rates foster lower margins.....we are possible heading to marginally higher rates at the moment due to the euro and the whale.

In my humble opinion it's not entirely about interest rates but also about willingness to lend to needy borrowers.

How can one borrow and lend safely in the midst of a currency crisis.
banks won't want to lend in euros If a year from now they may get paid back in drachmas or lira or pesatas at god knows what exchange rate.
Uncertainty demands higher rates of return.

Markie Mills:

Do you have a copy of Wall Street revalued by Andrew Smithers?
Page 73 first paragraph.

Referring to CAPE . . . we (can) know (IF) the market will be at fair value providing two conditions are satisfied - first - profits at equilibrium level, second that the market is selling at its average multiple.

He goes into a detailed comparison of CAPE and q in that chapter - 8.

Carlson73:

Getting back to Jeff's original question, I don't think the issue is that Schiller followers are actually looking at estimated earnings, as much as they are saying current earnings levels are not sustainable, so in effect, the current P/E ratio is really understated versus earning at normal sustainable levels of profitability. If I am doing the arithmetic correctly and the claim that profit levels are 50% higher than normal as a percentage of sales is true, a correction of that profitability level would mean current stock prices really represent a market P/E of something like 22 versus the 15, or whatever it is at the moment, we currently think we are at.
The arguments put forward by James Montier at GMO and several others in the last three months specifically argue that the deficit spending level, and low pressure for wage increases, has specifically supported profitability levels 50% higher than normal and that is likely to change next year no matter which party wins because both will have to do something to reduce the deficit.
Basically, a reversion to the mean in profitability would drive stock prices down.That is my understading of the argument.

Untrusting Investor:

Regardless of the pros or cons regarding CAPE or Schiller, the central question is did CAPE-Schiller methodology show, in the past, "optimum" points to buy equities and sell equities as LT investments? And the answer is that it almost surely does. And if so, then why would one question whether or not it will continue to do so if it was successful over multiple past market cycles? Thus, it appears that the only rationale to disregarding CAPE is that "this time it's different". But of course past market history shows that it is never different for the market as a whole over time.

Rich:

Also, Jeff, as to your critique of Shiller's prediction. You are basically saying that it's hard to trade based on Shiller's valuation metric, and therefore that his 10 year forecast is invalid. But that doesn't follow. It is well documented that the Shiller PE is very predictive of long term (ie 10 year) returns. For near term returns, it has no predictive value (hence it being tough to "trade" on) -- but that does not invalidate a long term forecast based on the Shiller PE.

I would agree with your summary if you said that Shiller's work provides no real guidance for traders. For investors, who by definition should be most concerned with long term returns, I completely disagree.

And most importantly, David Merkel wrote a thoughtful reply, which deserves a complete reading. He sees both pluses and minuses on the issue, and his viewpoint is helpful. His key point is that profit margins will revert when labor scarcity increases. Yes! And many other things will also happen at that time, including a better economy and stronger revenues.

My Summary of the Comments

I confess that I was discouraged by the comments. Most of the Shiller disciples seem to use the profit margin matter as an excuse for why the method has not worked. The Smithers fans are in another universe, as I explained here. Rich claims to have made money by jumping the gun on the lame "buy signal" in 2009 but he started selling right away. Those who talk about how well the method "worked" are not distinguishing between back testing and real time. You could go back to the era of high interest rates and make almost any investment. Try comparing Shiller's approach to a zero coupon bond, just to take one example.

The investment world hates professors unless they find one that supports what they already believe. In research design, the first question you ask relates to determining what data are relevant. By reaching back to the 19th century, Prof. Shiller proves that he has not started with the right question. I strongly recommend that investors ignore any research that does not justify the time period selected.

How to Profit from the Shiller Method

Since I am such a skeptic, readers may wonder how I have been persuaded.

It is pretty simple. Do not use the Shiller approach for market timing. Instead use it for relative sector ratings. Here are the rules:

  1. Stay 100% invested all of the time. Do not try to time the market.
  2. Determine the average CAPE ratio for the leading market sectors.
  3. Find the sectors that are trading at the biggest CAPE discount - the best choices.
  4. Throw out the very worst sector, since the market skepticism there might be justified.

This is rather like the Dogs of the Dow approach, especially the modifications where the very worse stocks are excluded. It has a little bit of a back-fitting feel, but even without this touch the Shiller sector approach beats the market on a back-tested basis.

The idea comes not from me and not from readers, but from the team at Barclays. It is endorsed by Prof. Shiller himself. You can see what he says in this video presentation.

This is much stronger than the usual application of the Shiller method. The key is for investors to buy the sectors that are showing relative value on the CAPE method. At the time of the webinar, this included industrials, consumer staples, health care, and technology. The method was discarding financials, which might actually be wrong.

The selected sectors are exactly the ones I have been recommending, except that I like financials as well. The main difference is that I have selected key stocks in these sectors instead of the Barclay's ETFs.

I am delighted that Prof. Shiller and I now agree on the best investment plan. I am not holding my breath while waiting for Hussman and Smithers to join us. They are missing out, as are those slavishly waiting for another CAPE "buy" signal for the overall market.

Meanwhile, here are the results for CAPE since the launch:

Cape

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: How To Profit From The Shiller CAPE Ratio