We are in the midst of a long Bull Market. Robert Shiller popularized the idea of Irrational Exuberance when he explained that people get overly excited about stocks when stocks are doing well, bidding prices up to an unsustainable level. Shiller’s Irrational Exuberance can be observed using the Shiller Cyclically Adjusted Price Earnings Ratio (CAPE 10), a price earnings ratio based on the average inflation adjusted earnings from the previous ten years. The measure simply shows us how stocks are priced relative to their average level of earnings over time. When prices reach an extreme relative to average earnings, Shiller would say that we are in a bubble. The logic of an investor might follow that when the Shiller PE gets too high, it’s time to bail out of the market and avoid the expected correction, getting back in when things are back to normal.
The current Shiller PE is starting to edge up on the high side, relative to history, at 25.09. It was 32.56 before the crash in 1929, it was at 44.2 before the crash in 2000, and it was at 27.53 before the crash in 2008. The overall historical mean Shiller PE is 16.54, and the median is 15.93. So, we are currently well above the historical average, and pushing up toward levels that have preceded a crash in the past. Does this mean that everyone holding stocks should sell into cash until the market has corrected? The data says no.
Tobias Carlisle (@Greenbackd) recently ran an experiment where he back tested the Shiller PE as a mechanism to move a portfolio of value stocks into cash at predetermined levels of overvaluation relative to historical Shiller PE levels. The value portfolio was defined as the Fama and French value decile, and the back test ran from 1926 – 2014. The result? The portfolios that used Shiller PE values to go into cash at various levels above the historical mean underperformed the control portfolio which maintained consistent exposure to the value decile. The underperformance was due to cash drag, and missing out on recoveries.
This doesn’t necessarily tell us that it’s impossible to time the market, but it does show that the Shiller PE is not particularly useful in doing so. Investors need to focus on holding the market portfolio with a consistent tilt toward established risk premiums, and stay invested.
original post at pwlcapital.com