Cyclically Adjusted P/E
Click to enlarge:

 

 

Meb Faber of Cambria Investment Management looks at 10 years of earnings. Based on a methodology developed by Yale University Professor Robert J. Shiller, Faber concluded from an analysis of cyclically adjusted price-earnings ratios, designed to minimize the effect of economic swings on profits.

Cyclically adjusted P/E, also known as CAPE, for U.S. stocks since 1900. The figures were obtained from Shiller’s Yale website, where they are available from 1881 onward.

The U.S. was among 32 markets examined in Faber’s study

Investing in markets whose ratios were in the bottom third at the start of each year would have produced inflation-adjusted annual returns that beat the global average by four to seven percentage points. Markets with ratios in the top third trailed by a comparable amount.

The results point to “significant outperformance by selecting markets based on relative and absolute valuation,” Buying only when CAPE was below 15 and shunning markets with ratios higher than 30 led to higher returns, the research showed.

 

 

 

Source:
Chart of the Day
By David Wilson
Bloomberg August 23, 2012

Category: Earnings, Quantitative, Technical Analysis, Valuation

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9 Responses to “Meb Faber: Buy Cheap Cyclically Adjusted P/E (CAPE)”

  1. wcvarones says:

    What’s the alternative? Treasuries at 2%? Cash which Bernanke has promised to devalue? Gold which we keep being told has no intrinsic value and is a “barbarous relic?”

    Maybe equities are the least ugly girl at the bar at 2am.

  2. DHM says:

    I haven’t read the Faber paper, so I have to be careful here. But the idea of buying equities only when CAPE < 10 means that 1989 was last year for purchasing? That seems insane.

  3. tgdc says:

    Shouldn’t we expect P/E’s to be higher when interest rates are lower, too? After all, if theory suggests the fundamental value of equities are the discounted future earnings, then when the future discount rates are lower the P/E ratios should be higher. I wonder what the graph would look like if you compensated by adjusting for the real 10 year treasury yield at each point in time.

  4. Vivian Darkbloom says:

    “Buying only when CAPE was below 15 and shunning markets with ratios higher than 30 led to higher returns, the research showed.”

    Eyeballing this chart, that would mean that the only periods during most readers’ investing lifetimes when this would apply to the US markets would have been approximately 1971 to 1990 and a brief period in 2009/2010. As I understand the model and how the returns were calculated, one buys stocks when the CAPE falls below 15 (and then holds until the market CAPE exceeds 30). One accumulates cash when the CAPE is above 15 waiting for the next opportunity. This then begs the question as to what one does with one’s money while waiting (sometimes a couple of decades) for the next optimal opportunity. Whether one has a “higher return” then depends on what the alternative investment is. The CAPE may not now be ideal for investing in the market, but will those future non-optimal returns exceed the opportunity for returns in alternative investments such as US Treasuries?

    Based on the chart, the idea of selling when CAPE exceeds 30 strikes me as a more robust idea than buying only when CAPE is below 15 due to the issue of where one should invest in the interim.

    Of course, the authors suggest a global approach that perhaps allows money to be invested at all times in some market where the CAPE is below 15 rather than just US equity markets. I wonder if the returns on a global basis were adjusted for currency valuations rather than just local inflation? I’ve only read the abstract.

  5. [...] Meb Faber: Buy Cheap Cyclically Adjusted P/E (CAPE) But don’t worry, it’s no rush for now. [...]

  6. mad97123 says:

    Who thinks a 10% loss in stock since 2000 is better than a marginal treasury return? Buying high-priced stocks does not pay over the long-term which is the point of the study. The fact that we’ve had “the rally of a generation” since 2009 does not eliminate the loss. If you think P/Es have moved to a permanently higher plateau, then gamble away on that thesis, it will work until P/Es revert to the mean.

  7. Sunny129 says:

    What to do with the cash between PE 30 and 15?

    No clear cut answer.

    My2cents:

    -retain a % (?) of cash for ‘long term’ investing
    - trade between extremes (?!) if you have the ‘guts’ for it, with options/long & short ETFs!
    - invest in Div paying blue chips and ETFs World wide, in different sectors and industries
    - $ average cost investing in selected Vang index funds

  8. Mr.-Vix-It says:

    This chart is inane. Even if you bought at a terrible time in the mid 1960′s at the secular bull market peak and right before a secular bear market, you would have done extremely well if you just waited until the next secular bull market.

    This time is no different. If you were dumb enough to buy at the secular bull top in 2000 and right before the secular bear we are currently in, you will still do well when the next secular bull market plays out.

    The simple truth that no one talks about is that you should accumulate as much stock as possible in a secular bear market and refrain from buying anything in a secular bull market. It’s the easiest way to make a lot of money but it’s too hard for people to do and they end up doing the opposite which is selling their holdings in a secular bear and then buying them back in the euphoria of a secular bull.

    The problem for a lot of investors is by the time they catch onto this, they are too old to make it until the next secular bull plays out. If we say conservatively that the next secular bull will top out between 2025-2045, you better make sure you are young enough now to have a high probability of making it into that timeframe or else the long-term equity game is probably over for you. The average lifespan in the U.S. should be higher by then but my guess is that if you over 45, you should not buy and hold thinking that the next secular bull will bail you out. Of course, if you leave it to your kids they can enjoy the equity riches but you won’t. Those that are under 45 should be putting every single cent in the stock market until this secular bear dies which is closer to the end than to the beginning.

  9. DiggidyDan says:

    Faber’s Quantitative Approach to Tactical Asset Allocation Strategy (as discussed here: http://www.ritholtz.com/blog/2012/01/revisiting-quant-approach-to-tactical-asset-allocation/ by BR and the Big Picture Community) would say you should be in a mixture of Domestic Stocks, Foreign Stocks, 10 Year US Bonds, Commodities, and Real Estate. Previously we discussed how the trigger for this is 10 month MA to jump in and out of each class, with BR and Mebane looking for a better “trigger” perhaps, the answer is not a “better” trigger, but instead a “conditional” trigger. I believe I have posited this before as I am a longtime follower of Mebane’s whitepaper and Mr. Shillers CAPE (along with the other valuation indicators seen on Doug Short’s site).

    If P/E 10 > 1 StDev above historical average and the 10 month MA sell signal triggers, sell, if within 1 StDev, ride it out.

    If P/E 10 < 1 StDev below historical average and the 10 month MA buy signal triggers, buy, if above, wait it out.