Economics Professor Valeriy Zakamulin: “If the Current P/E10 Ratio Is Near the Long-Run Mean, the Shiller Model Cannot Predict Anything.”

I have been sending e-mails to numerous people letting them know about my article reporting on The Silencing of Academic Researcher Wade Pfau by the Buy-and-Hold Mafia. 

Yesterday’s blog entry reported on my correspondence with Economics Professor Valeriy Zakamulin. Set forth below is the text of his next e-mail to me:
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Hi Rob,

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I looked at your blog, you advocate the Shiller’s PE10 model. It can indeed predict returns to some extent, and this model is very popular among practitioners.

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Yet the majority of people do not understand correctly the implications of this model.

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The correct implication that everyone understands: if the current PE10 ratio is way too far from its long-run mean, then there is something extremely wrong with the valuation. In this case the model predicts that sooner or later there will be a big correction.

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The incorrect implication: the majority of people believe that the Shiller’s model implies that if the current PE10 ratio is near the long-run mean, then the market valuation is correct and one should expect the returns equal to the long-run mean returns. The problem is that people do not really understand the nature of mean reversion. The mean reversion is not just returning back to the mean. What the Shiller’s model really implies is that “an excess in one direction will lead to an excess in the opposite direction”. So if the market was highly overvalued in 2000, then the PE10 ratio should first decrease to the mean, then move further down so that the market will be undervalued. Every secular bull market starts at a PE10 value which is way below the long-run mean.

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You need to understand the following: IF THE CURRENT VALUE OF PE10 RATIO IS NEAR THE LONG-RUN MEAN, THE SHILLER’S MODEL CANNOT PREDICT ANYTHING!

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To understand, just look at the chart of PE10

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http://en.wikipedia.org/wiki/File:S_and_P_500_pe_ratio_to_mid2012.png

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For example, at about 1970 and 1990 the PE10 ratio was at the long-run mean. Did it mean that the 10-year return would be “average”? On the contrary, during 1970s the stock market return was way below average whereas during 1990s the return was way above average.

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Valeriy

Comments

  1. says

    I don’t know. I’m a pretty darn determined son of a gun, Canyon.

    But it’s fair to say that the market can stay irrational for a LONG time. I think I need to give you that one.

    Rob

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