CAPE Shiller Index

[Nomad]

I've been hearing about the CAPE Shiller Index for a while; the cyclically adjusted price to earnings ratio for US stocks.

http://www.multpl.com/shiller-pe/

At present, it is very high which indicates that stocks are arguably about 200% of fair value and a 'price readjustment' could quite
easily see them lose 50% of current value...

So, what are peoples views on this and what is the best place to put your money if you are expecting a 'correction' fairly soon?

[ThisDinosaur]

Shiller's index is useful for predicting the average total return from a country's stock market over the following ten years. But it's not good at predicting corrections or short term returns. The market could "irrationally" keep going up for years.

http://www.themoneyillusion.com/2001-a- ... of-sample/

So I don't think it's a good idea to stay out of US stocks altogether. You could hold undervalued stocks, specific sectors, low CAPE foreign stocks, or just keep your domestic stock allocation below 50%. I happen to be doing all of those things.

[Seppia]

As mentioned above, don’t use cape to try time the markets, it’s a terrible short term predictor.

This said, pretty much everybody and every valuation metric agree that the USA market is richly valued, and that the 10-15 year prospects aren’t great at all.

Some say cape has been higher than the historical average for the last 20-25 years as a result of easier access to investing, cheaper ownership costs, transaction costs, less fraud, thus resulting in lower “risk” investing in stocks, thus increasing the PE multiple people are willing to pay.

I think there may be a little bit of merit to this, but then why european stocks are much closer to their historical averages then?

Another thing to keep in mind: the correlation between cape and future returns is highest for a 10-15 years time horizon, then it decreases significantly for 25-30 year periods.
So depending on your age and time horizon it may not matter as much.

Things you could do:
- increase your cash allovation
- increase your percentage of non-USA stocks
- shift to more defensive sectors or type of investments (Wellesley is popular here)

I think the above are things you can consider, especially if they can help you sleep better at night and deal with an eventual downturn.
Remember the #1 thing you want to avoid when investing are catastrophic mistakes (selling at the bottom, going all in at the top of a bubble because of fomo), so whatever tricks your mind into avoiding them is always smart to implement, even if statistically you’d be better with a more aggressive play.

[jacob]

Be careful about investing in foreign/world stocks willy-nilly just because their CAPE is low. CAPE is a proxy for "market cap/GDP" and if you look around, you'll find different countries to have very different ratios. For example, Italy and Russia have very low values. Switzerland and Singapore have very high values.

Much of this has to do with how businesses are financed in the given country and also how monies are invested. If banks tend to lend out most of the money, then the equity market will not be big. If tax laws favor bonds or real estate, the equity market will not be popular. Such tax laws, regulations, and institutional development determines the different capes.

In a given country (especially the US with its reserve currency), stock market performance and thus CAPE is strongly influenced by currency movements. In USD dollars, the US market did great in 2017. However, this evolution was paralleled by a 10%+ drop in the USD relative to the EUR, so in EURo terms, the US stock market wasn't spectacular. This matters if you're spending in Euro. Similar effects with GDP and the British market following Brexit. GDP dropped, but the market did well(?) afterwards after the initial banking shock.

Some funds allow you to get around the currency effect and invest in fundamentals by hedging the exchange rate for you.

[ThisDinosaur]

CAPE is a proxy for "market cap/GDP"

I use both of those metrics when I buy foreign markets. But, if I recall, CAPE is the better predictor. Do you know otherwise? I can't find a reference either way at the moment. I would expect both GDP and asset prices to be down during a recession.

Your second point, about how financing is usually obtained, seems like it would only be relevant if there was a *change* over the last 10 years.

Thirdly, exchange rates are more unpredictable than stock markets, but my understanding is that rising GDP leads to greater export/import ratio, which leads to a stronger currency. This would, on average, increase amplitude of both positive and negative returns.

Show me where I'm wrong.

[jacob]

I don't know otherwise. Cap/GDP is a lot easier to calculate though. CAPE certainly makes more sense because it measures the market directly and not everything.

On my second point, I disagree unless you're just arguing for using CAPE to speculate on mean reversion in a 10 year trading range. What I'm suggesting is that different countries have different inherent ROIs due to the different investment structures in the respective countries. For example, the returns on the Italian stock market have historically been rather bad. As a result, the SWR in Italy is very low. It's not surprising that CAPE is also low relative to other countries. People need a lot of earnings for each Euro they put into it.

On the third point, long term (5-10 year) exchange rates are actually one of the few consistently predictable trades where simple technical signals work. The other factors that drive exchange rates are interest rates, pegs, and reserve status.

[liberty]

@jacob Equity is real stuff: Boats, planes, ideas, software etc... Why then care about currencies? The equity is still the same independent of currency markets.

[jacob]

@liberty - Because ultimately you have to sell it again/receive dividends and get paid in a currency (presumably your own). There are very few and as far I I know nobody on these forums who buy equity in order to gain a controlling interest in the company.

[liberty]

@jacob Yes that's right, but I'm still not sure if that really matters. If a currency performs bad, the stock market performs equaly better measured in local currency? It's easy for US to perform good in local currency when USD looses 10% to EUR. Venezuela's stock market went up 3,833% last year, but their currency went down 97% relative to other currencies.

I can't see how this currency thing is an argument against CAPE. Regarding Italy:

It's not surprising that CAPE is also low relative to other countries. People need a lot of earnings for each Euro they put into it.

And they get a lot of earnings. Let's say CAPE is 10 and you buy Italy today and hold for one year. If the earnings continue in the same pace and the valuation is still the same (CAPE 10), you will get a 10% return (1/10). That's a great return! I don't bet on mean reversion of CAPE rations, I buy an income. I get the earnings yield (reversed P/E) as return if the earnings and valuation stay the same.

[Seppia]

Couple of important details:
1- you don't get to bank the earnings, it's not your own business.
What you can get are the dividends, and the eventual capital gain/loss.
These can be very independent from the earnings (ie Apple makes more money in a quarter than amazon has made since its IPO, yet the amazon shareholder has been handsomely rewarded)

2- earnings can also go down. Italy has a lower gdp today than in 2001 in real terms IIRC

[liberty]

Dividends vs other use of earnings doesn't really matter, I think. The earnings are still there anyways. My example:
- The earnings continue at same pace in the next year as average the last 10 years (the denominator in CAPE).
- The CAPE-ratio is still the same 1 year after

In this case you would have got 10% return if the CAPE-ratio is still the same after 1 year. A CAPE of 10 yields 10% per year (1/10) given that earnings still the same. It's not paid out as a dividend, but the money is still there, and you will get them as a price return.