CAPE

The Invest It Wisely blog last week posted an article that is exciting for two reasons. One, it advocates Valuation-Inforemd Indexing. Two, it was not written by Rob Bennett!

This is the sort of thing we need to see to get the ideas we have been talking about and developing in the Retire Early and Indexing discussion-board communities for nine years now into the mainstream. We are beginning to see signs of what I have long dreamed of — a “Normalization” of our discussions of the realities of stock investing.

The article is by Mathieu Bouville and is titled The CAPE: How to Beat Stocks with a 50/50 Portfolio. It’s super stuff.

Juicy Excerpt: Figure 1 shows the annualized real return over the next 20 years as a function of the current CAPE. When the CAPE was below 10, the return of the S&P 500 has never been below 5% p.a. over the next 20 years (i.e. one at least multiplied one’s purchasing power by 2.7). And it has never been above 3% when the CAPE was above 23. (This does not mean that this will never happen, just that it is quite unlikely.) With the 1999–2000 CAPE of more than 40, it is hard to see how one could dream of making money in the long run…. If the CAPE has some predictive power, it can be used to improve the efficiency of one’s asset allocation.

The blogger who owns the Bad Money Advice site has put forward a post offering reasoned skepticism re the Valuation-Informed Indexing strategy. The title of the post is The Truth About the Shiller PE. Good stuff, Frank!

Juicy Excerpt #1: “I do not know that Prof. Shiller has ever gone so far as to advocate that people use cyclically adjusted PE (CAPE) to make investment decisions.”

Juicy Excerpt #2: “Shiller does his best to warn people off relying on CAPE, saying that it ‘has to be interpreted with great caution’ and that its observed predictive power could be ‘a chance relation with no significance.’ ”

Juicy Excerpt #3: “A scheme that will tell us if stocks are a good or bad buy without any reference to the relative prices of other potential investments is more than a little suspect.”

Juicy Excerpt #4: “Valuing the market relative to its own history, that is, comparing the current price to the long-run average, implicitly makes the assumption that there exists some kind of true or natural price level for the stock market.”

Juicy Excerpt #5: “Using monthly observations of CAPE and the 10 year forward real stock market return from January 1881 to January 2000, I get a correlation of –0.44. That corresponds to an R squared of 0.19, which is impressively strong in the world of finance.”

Juicy Excerpt #6: “Things get weird fast if you suppose that CAPE works on ten year but not one year horizons. Are we to make only ten year stock market commitments?”

Juicy Excerpt #7: “The practical sample size is a lot closer to 12 than it is to 1440.”

Juicy Excerpt #8: “To effectively test this as an investment strategy we need to restrict the inputs to just data that could have been available to an investor at the time.”

Juicy Excerpt #9: “Back in 1932, modern cap-weighed indexes as we know them, with accessible figures on such things as composite earnings, did not then exist. Which means that although investing on GCAPE was conceptually possible, as a practical matter it was not really an option.”

Juicy Excerpt #10: “One of the great principles of financial economics is that anomalies such as simple and effective ways to time the market do not persist for long because investors will spot them and price them out of existence.”

Juicy Excerpt #11: “It may be a fair statement that, on average, over 120 years GCAPE (and CAPE) has been somewhat predictive of stock market returns, but most or possibly all of that predictive success happened long long ago. During my lifetime, it has not been much of a help.”