David Leonhardt published this graph from Robert Shiller in his piece in the NY Times:
I have one major issue with this: stock values are based on FUTURE earnings, not PAST earnings. The two are only related if earnings for the past 10 years are indicative of earnings for the next 10 years. I suspect that the next 10 years will present a whole new rash of unforeseen problems, but will be nothing like the last 10 years — any more than the period 2001 to 2010 resembles 1991 to 2000 (or 1981 to 1990).
Shiller’s research indicates the higher the market price (using CAPE), the lower the subsequent 10 year investment return. This research is valid across any past decade you care to analyse. This time it’s different? Well, I guess we’ll see in time.
Looking at Shiller’s graph, we can conclude that CAPE > 20 is overbought and CAPE < 10 is oversold. In 1994 we would have sold all our stocks and 2 decades later would still be waiting for the market to go oversold so that we can re-enter. During which time the S&P 500 has gained more than 300% (459 to 1878).
Actually, at CAPE 20 you don’t sell your stocks – provided you accept the historical likelihood of averaging around 5%pa over the next ten years (within an approximate 0%pa to +10% pa band; see Irrational Exuberance). At CAPE 25 the likely 10 year return is closer to zero (eg. 1998 through 2008 played out according to the probabilities). Doug Short (Advisor Perspectives) has calculated the correlation at 0.99. But like all valuation tools it’s blunt – and should not be used as a buy/sell indicator, rather as a measure of market risk and a guideline for passive investing expectations.
At what level do you sell? CAPE 25 or CAPE 30?
Also important to realize is the interest rate is at an all time low and will remain at an all time low for the foreseeable future. The US government will have no choice but to keep interests rates down because of the unbelievably high debt. Because of the discrepancy between the dividends paid by well run companies and that paid by the treasury and banks the stock market will continue to go up, up, up!!!
The only fly in the ointment would be if earnings take a dive and the low interest rates will make it easier for companies to continue to increase their earnings.
Interest rates, taxes and real wages are all low. The first two are unlikely to last forever. Low real wages are partly a result of increased globalization and are only likely to recover if the Dollar significantly depreciates against other major currencies, especially from Asia.
Personally I adjust my risk management using CAPE (eg. tight stops, hedge on US stocks) and also adjust asset allocation (eg. prefer some Euro markets on CAPE 10 to 12 compared to US stocks on CAPE 25.) Greece is on CAPE 5 and for the brave Russia is around CAPE 6.
My point is that in 1994 it is unlikely anyone would have been using CAPE 25 for US stocks. So something has changed.