Wade Pfau on High CAPE ratios

[Lsbcal]

Quote:

Originally Posted by kevink This is a short, two-part series that ought to be of interest to many of us. He's advocating reducing equity exposure to 25% when stocks are in nosebleed territory - as they are right now. Part 1 is here: Is a High CAPE Cause for Alarm? Part 1: CAPE's Relationship to Stock Returns And Part 2: Valuation-Based Asset Allocation

If one were going by this strategy, it looks like they would have been at only 25% equity through most of the market since about 2011. From the start of 2011 the S&P500 is up about 86%.

[Texas Proud]

Quote:

Originally Posted by Totoro It's a scatter plot, not a time series. X-axis is CAEP-10 (inverted CAPE-10). So a CAPE-10 of 25 is 4%. Y-Axis is the subsequent 10-year annual real return of the S&P 500 (as per Shiller's data), excluding dividends. Also in % Every blue dot is one data point of a given month. So for a given month, what was the 1/(CAPE-10) and what happened in the subsequent 10 years with the S&P 500 (real annual return ex. dividends). All months starting from end 1929 up to 2012 are included. I hope this clarifies a bit? If not, let me know. Maybe the graphics format is messed up (it works ok here, but you may use a different browser), I can repost in a different format then.

Ok... now makes sense to me.....


The question I have is there one that would show different time periods....

IOW, I bet that all those data points between 2% and 4% CAPE are during the same time period...

You can kinda see some trend lines in that data that also appear to be other time periods...

It would be interesting to see if the data is still negative sloping if there were one or two time periods taken out... IOW, does it hold all the time or are there a couple of periods that really make a difference to the trend....

[Live And Learn]

My head hurts !!!!

[Texas Proud]

Quote:

Originally Posted by kevink This is a short, two-part series that ought to be of interest to many of us. He's advocating reducing equity exposure to 25% when stocks are in nosebleed territory - as they are right now. Part 1 is here: Is a High CAPE Cause for Alarm? Part 1: CAPE's Relationship to Stock Returns And Part 2: Valuation-Based Asset Allocation

OK... not as good as I was thinking....

The relationship is far from exact as there is still a lot of randomness to be found in the numbers, but statistical analysis suggests that PE10 can explain about 31% of the fluctuations in real stock returns over ten-year periods.

That leaves a lot of explaining to do....

[Totoro]

Quote:

Originally Posted by Texas Proud The question I have is there one that would show different time periods.... IOW, I bet that all those data points between 2% and 4% CAPE are during the same time period... You can kinda see some trend lines in that data that also appear to be other time periods...

Same graph with starting time periods grouped by decade and time period (latest start is around 2002 - so you get returns up to 2012). I realize it doesn't look pretty (hey, this is a hobby!), hope it does make sense.

Red is 20s, 30s and 40s.
Green is 50s, 60s and 70s.
Blue is 80s, 90s and early 00s.

Individual shapes gives distinction between individual decades.

I made a typo in my earlier clarification: y-axis is real return including dividends (as per the title), but without re-investing said dividends.

[Edit] Please let me know if you see something unexpected -- no garantuees that I did the analysis fully correct ..

[Lsbcal]

Quote:

Originally Posted by Totoro ... I personally check CAPE & inflation rates. Specifically I look for when yield minus inflation drops below zero. Sign to head for the exits usually.

I'm wondering where you got this thought. It doesn't seem to spring from the graph you have shown. I guess that value would be:

1/CAPE - inflation = 1/26.7 - 0.1% = 3.7% - 0.1% = 3.6%

[Texas Proud]

Quote:

Originally Posted by Totoro Same graph with starting time periods grouped by decade and time period (latest start is around 2002 - so you get returns up to 2012). I realize it doesn't look pretty (hey, this is a hobby!), hope it does make sense. Red is 20s, 30s and 40s. Green is 50s, 60s and 70s. Blue is 80s, 90s and early 00s. Individual shapes gives distinction between individual decades. I made a typo in my earlier clarification: y-axis is real return including dividends (as per the title), but without re-investing said dividends. [Edit] Please let me know if you see something unexpected -- no garantuees that I did the analysis fully correct ..

Nothing unexpected.... it was like I was thinking.... that the decades followed a certain slope... IOW, the slope for any particular decade looks similar even though the various decades do not have the same slope...


But, all going in a downward trend with higher CAPE....

[NW-Bound]

Just because P/E is high doesn't mean that stock prices can't go up.

[Totoro]

Quote:

Originally Posted by Lsbcal I'm wondering where you got this thought. It doesn't seem to spring from the graph you have shown. I guess that value would be: 1/CAPE - inflation = 1/26.7 - 0.1% = 3.7% - 0.1% = 3.6%

It doesn't show in the graph as the individual CAPE-10s aren't corrected for inflation. Current result in the US indeed would be around 3.6%, so it seems "safe" for this signal.

Note that this is a short term indicator. As in, get out NOW while the indicator is negative, and get back in once it is positive.

1/CAPE - inflation (yoy) has been negative in the following periods (between brackets index evolution):

• Late 1941 to mid 1945 (9.8 -> 8.6)
• Mid 1946 to mid 1948 (18.1 -> 16.4)
• First half 1951 (22.0 -> 21.6)
• Late 1968 to early 1970 (103.8 -> 87.2)
• Mid 1973 to mid 1975 (103.8 -> 92.5)
• Mid 1979 to early 1981 (107.4 -> 128.4)
• Late 1999 to mid 2001 (1318 -> 1239)
• Late 2005 to mid 2006 (1226 -> 1260)
• Late 2007 to late 2008 (1463 -> 1217)

So with the exception of 1979 and 2005 the signal worked pretty well in the past. Even in 1979 it wouldn't have been that bad. Bond yields were pretty high then too (10%) so you wouldn't have lost out much, if anything. And 2005 is basically a flat result.




Some notes:

• It doesn't miss all the dips by a long shot. It just gets you out for some dips, big and small.
• There is a strong correlation with interest inversion signals - so it's not really new.
• It is a short term signal, so if inflation is unstable it can be confusing.
• Most "avoid" periods are pretty short. You'll need some major cojones to act on it.
• It seems to get positive again too early (e.g. 1970, 2002, 2008)

I have an underlying excel -- Should make some pretty graphs with it and update for the last 3 years of data. I took most from Shiller though, and his website update makes pulling down the Excel with raw data harder to do now.



And as with everything, it might be a fluke or pattern which doesn't say anything really. Intuitively though for me it makes sense (negative real yield = sign of overpricing).



A bit short on time in the coming months also, but let me know if you're interested.

[Lsbcal]

Totoro, thanks for the thorough explanation. I have a model which uses the yield curve (strong dependency) and PE10 (weak dependancy) plus the SP500 returns versus bonds. Since you mention that 1/CAPE - inflation is strongly correlated with the yield curve, it might be somewhat similar. I'll look at my data and check it out.

[photoguy]

Quote:

Originally Posted by Texas Proud OK... not as good as I was thinking.... The relationship is far from exact as there is still a lot of randomness to be found in the numbers, but statistical analysis suggests that PE10 can explain about 31% of the fluctuations in real stock returns over ten-year periods. That leaves a lot of explaining to do....

I think we should consider that maybe PE10 is about as good as can be done by *any method* and there's no more to be explained - the remaining 69% is noise and will never be modeled.

[Options]

Quote:

Originally Posted by Live And Learn My head hurts !!!!

Here's a great antidote:

Top 41 Rick Ferri Quotes - Fund Reference

Specifically:

Quote:

Rick [Ferri]on Predictions On media predictions: Don’t believe what you read or hear in the media about where a stock is going or where the market will be by a certain date. The people who make these predictions have no idea what prices will be in the future. They do it just for attention. Following their advice will probably make you poorer, not richer. On guru predictions: Guru predictions are not investment advice — they are entertainment. Treat them as such and you will be better off for it. On TV appearances: Don’t ask famous market gurus if you want to know where the markets are going, and don’t listen to their advice when you see them on television or hear them on the radio. On market timing: If you want market timing advice, try a shiny new penny. It’s more accurate than the gurus. On networks and predictions: But it doesn’t matter that forecasters can’t predict. The networks aren’t keeping score. Why would any producer let bad forecasting get in the way of good theater? On marketing: The more things change, the more they stay the same. There weren’t any market timing experts in the 1980s and 1990s, and there haven’t been any since. There are no experts at predicting markets — there are only experts at marketing predictions. On predictions: People can’t predict markets but markets can predict people.

[NW-Bound]

Quote:

Originally Posted by photoguy I think we should consider that maybe PE10 is about as good as can be done by *any method* and there's no more to be explained - the remaining 69% is noise and will never be modeled.

Do we call "noise" a myriad of other factors, things that are too complicated to consider in a simple number like PE?

What about lack of other investment opportunities, low interest rates, low bond yields, few foreign markets with geopolitical stability, currency exchange rate, etc...?

[haha]

Quote:

Originally Posted by photoguy I think we should consider that maybe PE10 is about as good as can be done by *any method* and there's no more to be explained - the remaining 69% is noise and will never be modeled.

I wonder if PE10 modified by some sort of momentum factor to prevent a very early exit from a blow-off might not help? It might be that in our modern era of politically controlled markets you do better by being less than completely rational.

In any case, it is hard to tax effectively use these methods unless most of one's funds are in tax protected accounts.

Ha

[Totoro]

I made a note to see if adding any such effect would make a difference.

Probably October before I get to it.

Big downside I can see is that you'll end up force-fitting - torture the data until it confesses ..

[clifp]

Intuitively I suspect that R^2 of .31 sounds about right for CAPE. I'm also inclined to think the universe and the market are too random and irrational to get a much higher correlation.

The problem I have is I don't see any alternative investment class that is in less over valued. I bet the "PE10" for bonds (e.g. 100/average yield of the 10 year treasury over the last 10 years) is probably near 40 which I bet puts them in even more nosebleed territory.

[HFWR]

Quote:

Originally Posted by haha It might be that in our modern era of politically controlled markets you do better by being less than completely rational.

I'm good...

[haha]

Quote:

Originally Posted by clifp Intuitively I suspect that R^2 of .31 sounds about right for CAPE. I'm also inclined to think the universe and the market are too random and irrational to get a much higher correlation. The problem I have is I don't see any alternative investment class that is in less over valued. I bet the "PE10" for bonds (e.g. 100/average yield of the 10 year treasury over the last 10 years) is probably near 40 which I bet puts them in even more nosebleed territory.

One difference in favor of bonds is that bonds with 2-4 year durations can be chosen. Yet the implied duration of an equity yielding 2.5% may be close to 50 years. There is also cash.

Ha

[samclem]

Quote:

Originally Posted by NW-Bound But for portfolio allocation, should we not also consider the prospect of alternative investments, such as bonds, precious metals, cash, etc...? Right now, the other asset classes do not look appealing either.

That's true. But if Pfau's data and analysis is right, when equities are in the present range, they typically return about 1.5% over the next 10 years. If we believe that says something about the future, maybe present returns in ST bonds, etc are more attractive--relatively.

Quote:

Originally Posted by haha One difference in favor of bonds is that bonds with 2-4 year durations can be chosen. Yet the implied duration of an equity yielding 2.5% may be close to 50 years. There is also cash.

Other work done by Pfau and Kitces suggested that, in reaction to PE10, investors should not only vary their % in equities, but change the "safehaven" from corporate bonds to ST govt bills when PE10s get high. I think the explanation for the historical outperformance of this strategy is that when the markets take a big drop (from a high PE10) that the subsequent "flight to quality" favors govt bills, but that the higher return from corp bonds during periods of more moderate equity valuations make them the better choice.

What Pfau is writing about in the links at the OP is ground he has covered before recently. We discussed it a bit here.

[NW-Bound]

Quote:

Originally Posted by samclem That's true. But if Pfau's data and analysis is right, when equities are in the present range, they typically return about 1.5% over the next 10 years. If we believe that says something about the future, maybe present returns in ST bonds, etc are more attractive--relatively.

But to play devil's advocate and to borrow the argument from the EMH camp, perhaps the market has also discounted the future returns of other assets, hence is willing to pay more for equities now.