Playing Chicken With Bulls And Bears

 |  Includes: DIA, QQQ, SPY
by: John Overstreet


CAPE does a poor job of predicting bullish returns in the years before market tops.

CAPE's failures to predict returns in these instances can be used to time the market instead.

We may be nearing the end of this bull market, but it probably has a couple of years left in it.

In a bull market (SPY, DIA, QQQ), the time to trust CAPE is when it is wrong. If you look at the following chart, you can see that during the great bull markets of the last 125 years, it was better to wait until the CAPE was nearly positively correlated with short-term returns before selling. We are approaching that sort of level now, but those conditions do not manifest themselves overnight. It takes years.

CAPE fails at market topsClick to enlarge

(Source: All data come from Robert Shiller).

In articles over the last few weeks, I have been writing about how the history of earnings growth illuminates fundamental rhythms of the market. It also allows us to rethink how traditional market metrics work.

I have noted that, due to reasons at least partly outlined in my previous article, the relationship between medium-term earnings growth and the unadjusted P/E ratio (price divided by the monthly earnings value) tells us something about the future of the market. As long as the two are negatively correlated, we should expect positive medium-term returns. In a nutshell, this appears to have something to do with how the market reacts to earnings volatility, specifically negative earnings shocks and their aftermaths.

Earnings growth correlation predicts medium-term returnsClick to enlarge

In the following chart, you can see that the correlation between earnings growth and the P/E ratio tends to behave a lot like CAPE.

Earnings growth correlation behaves a lot like CAPEClick to enlarge

That correlation has a slight advantage when it comes to predicting medium-term returns.

CAPE not so hot at short-term returnsClick to enlarge

In this article, however, I want to shift the focus from predicting future returns to the question of timing.

So, to repeat, the correlation between the earnings growth rate and the unadjusted P/E ratio tends to behave like the CAPE ratio, but breakdowns in that correlation (where earnings and P/E become positively correlated and therefore bearish) tend to coincide with periods when CAPE fails to predict bull markets (compare the previous and following charts).

earnings growth rate vs P/E ratioClick to enlarge

That is because of the way that bull markets end: with a bang. Parabolically.

In the closing stages of a bull market, the medium-term earnings growth rate rises, year-on-year earnings growth becomes placid, and stocks balloon. This is what makes the relationship between the earnings growth rate and P/E predictive, and it is the deliberate exclusion of the earnings volatility factor that makes CAPE incomplete.

When that medium-term earnings growth rate begins to rise with P/E, that is a signal that subsequent medium-term returns will be lower, but the immediate effect is bullish.

In part, this has to do with the fundamental weakness in the construction of the CAPE ratio. In order for CAPE to predict those terrible bear markets, it has to first climb up to immense heights, but in order for it to climb those immense heights, it must, for a time, defy its own bearish predictions. If the market were perfectly cyclical, so that markets rose and fell every ten years, this would not be a problem, but the market is not perfectly cyclical, of course. Or, if CAPE's movements were not primarily determined by movements in prices (rather than earnings), there might be a way for the relationship to work without cyclicality, but price has always been the driver behind CAPE, for better or worse.

In sum, I argue that the correlation between the earnings growth rate and P/E can give us a fair estimation of what medium-term returns will look like, but that it can also be used to time the market to some degree.

Wait until you see the whites of their eyesClick to enlarge

And, when you add up all that has been said about CAPE above, we can say similar things for that ratio. CAPE does a fair job of predicting medium-term returns, except when it fails to, in which case it can be used for timing market tops. As you can see from the first chart, that top does not seem to be in quite yet.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.