Shiller CAPE And Contrarian Investing

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Includes: SPY
by: Clint Sorenson, CFA, CMT

Summary

Allocate investments using the Shiller CAPE.

Capitalize on sentiment extremes by acting contrary to the herd.

Adapt to changing markets to produce return enhancement and risk reduction.

In the Wall Street Journal article Yes, You Can Time the Market, Spencer Jakab gives readers a glimpse into the world of value-based asset allocation. In the article he simply espouses that if an investor would have rebalanced a balanced portfolio of 60% stocks and 40% bonds based on the CAPE (cyclically adjusted price to earnings ratio), investors would have been much better off since 1926. Robert Shiller popularized the CAPE in his book Irrational Exuberance where he recommended dividing the current price of the S&P 500 by a 10 year average of historical earnings. The measure is actually attributed to Benjamin Graham and Frank Dodd and was often referred to as the Graham and Dodd P/E. Nevertheless, the origins are not the concern, what is of concern is the merit of the measure. Using historical earnings removes the dependency on predicting the future and all the inherent behavioral biases. Moreover, a long term average of earnings is useful in that it reduces the effect of the extreme earnings in either direction, providing a normalized earnings picture. The CAPE also has demonstrated an inverse relationship to long-term (10 year +) future returns. Historically, high CAPE values have led to low returns and low CAPE values have led to high returns.

Image by Meb Faber, CMT, CAIAThere has been a great deal of criticism on the measure as of late with many critics viewing the metric as dated or no longer useful. Our opinion is that most of the doubts come from an erroneous application of a still useful tool. Specifically, most of the critics attempt to use the Shiller CAPE to time short term market moves. The CAPE is instead is most useful as a guide to future expected returns over a long period of time.

To demonstrate the CAPE's effectiveness we have decided to run an analysis where we rebalance a moderate portfolio of half stocks and half bonds according to the CAPE (50% S&P 500 and 50% 10 Year Treasuries). We call the strategy the Value Allocator™ and the rules are as follows:

•When CAPE is in top 25% of historical observations, rebalance allocation to 30% S&P 500/ 70% 10 Year T Bond

•When CAPE is in bottom 25% of historical observations, rebalance allocation to 70% S&P 500/ 30% 10 Year T Bond

•During all other time periods, the CAPE will be allocated to 50% S&P 500/ 50% 10 Year T Bond

The test compares an investment of $100,000 in a 50% S&P 500 / 50% 10 Year T Bond blend and $100,000 invested in the Value Allocator beginning in 1928. Through 2013, the balanced portfolio of half stocks and half bonds grew to an impressive $65,263,846. The balanced portfolio compounded at north of seven percent per year over the entire time period. The Value Allocator strategy, on the other hand, grew to a whopping $123,423,907 through 2013, compounding at roughly nine percent and nearly doubling the results achieved through classical balanced approach.

Image by Clint Sorenson, CFA, CMTThe difference in ending values is largely due to the ability of the CAPE to pick up extreme levels of sentiment. When valuations are in the top quartile, sentiment is often extreme and euphoric markets are present. On the flip side, when valuations are in the bottom quartile, sentiment is often extremely pessimistic. The strategy responds to the extremes in sentiment to rebalance the portfolio from a contrarian viewpoint. The Value Allocator strategy takes advantage of the irrational market participants by measuring when the market is overly optimistic or overly pessimistic and reacting accordingly.

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.

Additional disclosure: Hypothetical Performance Results Have Many Inherent Limitations, Some Of Which Are Described Below. No Representation Is Being Made That Any Account Will Or Is Likely To Achieve Profits Or Losses Similar To Those Shown. For Illustration Purposes Only.This data reflects the different assumptions, views and analytical methods of Emerald Asset Management as of the date of this presentation, prepared in response to a specific request.