Shiller's Cyclically Adjusted Price Earning Ratio as Long Term Timing Indicator

Yale Professor Robert Shiller has devised and maintained a so called "Cyclically Adjusted Price Earning Ratio" (CAPE10) as an alternative to the popular P/E ratio to value the US stock market. CAPE10 is defined as the ratio of price to the average of last 10 year trailing S&P 500 annual earnings. In his now famous book titled "Irrational Exuberance", Shiller popularized this ratio as a long term stock market valuation metric. As it stood last Friday, October 23, 2009, the current CAPE10 is 24.08 while the long term average CAPE10 (since year 1881) is 16.34. This implies that the current US stock market is 35% over valued.

It is interesting to examine how effective using such a metric as a long term stock market timing indicator. Similar to Warren Buffett's stock market metric, ValidFi implements and maintains a live strategy called Shiller Cyclically Adjusted P/E 10 Stock Market Timing Strategy. One of its model portfolios buys stocks only when this ratio is deemed to be significantly under valued (the current CAPE10 is 33% lower than the long term CAPE10 average) and goes into cash when such a ratio signals significantly over valued (if the current CAPE10 is 50% higher than its long term average). The stock market exposure is through buying Wilshire 5000 total return index (^DWC). From 12/31/1970 to 10/23/2009, the weekly adjusted portfolio achieved 7.5% annualized return and standard deviation 9.5%, compared with Wilshire 5000 total return's annualized return 6.9% and standard deviation 19.5%. Such a portfolio was in cash from 7/17/1987 all the way to 3/6/2009. See the following chart:



It is hard to believe that an average investor would have such patience to stay out of the stock market for such a long time, especially during the bull markets. However, a prudent investor would utilize such an indicator to carefully manage the risk during over valued periods.

Some readers might ask that since Shiller's indicator is a long term indicator, what strategies one could use during the long time periods when it is out of the stock market. We will have follow up articles on how to combine such a long term indicator and some safe strategies to achieve safe and more reasonable returns.

Disclosure: No Positions