How does the Shiller P/E (“CAPE”) perform as a stock selection tool?

/How does the Shiller P/E (“CAPE”) perform as a stock selection tool?

How does the Shiller P/E (“CAPE”) perform as a stock selection tool?

By | 2017-08-18T17:03:39+00:00 October 1st, 2013|Research Insights|12 Comments

On the Performance of Cyclically Adjusted Valuation Measures

Abstract:

We confirm the effectiveness of using cyclically-adjusted valuation metrics to identify high performing stocks. The Shiller P/E, or cyclically-adjusted price-to-earnings (CAPE) ratio, is not the optimal way to implement a cyclically-adjusted value measure. At the margin, the cyclically-adjusted book-to-market (CA-BM) is a better measure to predict returns. We find that more frequent rebalancing and momentum can enhance strategies based on cyclically-adjusted valuation metrics.

Data Sources:

CRSP/COMPUSTAT.

Alpha Highlight:

Cyclically-adjusted valuation metrics, or measures that sort stocks on 10-year average real earnings (or Book, EBITDA, FCF, GP, etc.) divided by the current real price (or total enterprise value in some cases), can be used to identify cheap securities. Annually rebalanced portfolios that purchase the top 10% cheapest securties based on these long-term valuation measures have outperformed the S&P 500 and the equal-weight S&P 500 over time.

cape1

[Click to enlarge] The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

How does the Shiller P/E stack up against other cyclically-adjusted measures?

cape2

[Click to enlarge] The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

All measures show an ability to identify cheap stocks that beat common market benchmarks over the long-term. At the margin, the cyclically-adjusted book-to-market ratio works better than the Shiller P/E, or CAPE.

Strategy Summary:

  1. Sort all stocks on your favorite cyclically-adjusted measure.
  2. Buy the cheapest 10%, equal-weight.
  3. Rebalance annually.

Commentary:

  • Many market commentators and participants are infatuated with cyclically-adjusted valuation metrics. There is no evidence that we are familiar with to suggest that these metrics are any better at sorting stocks than simple trailing twelve month measures.
  • Adding momentum and more frequent rebalancing can enhance these ratio’s ability to identify winners and losers.

Time to dump CAPE and fire up CA-BM?


  • The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).
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About the Author:

Wes Gray
After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.
  • Remmelt Ellen

    Going back to my previous comment (hopefully) appearing here now, does the fact that the risk measures (Sharpe, Sortino & max. drawdown) are much better for the QV method mean for you that the QV method remains superior even if 10yr B/M with momentum and monthly rebalancing has better CAGR?

  • Remmelt Ellen

    Seems like I needed to post my previous question in parts.

    Dear Wesley Gray,

    Thank you for all the great information you have been posting. The studies and reasoning for going quant have really convinced me that that is a very logical way to go (unless you’re a younger Warren Buffett).

    I have some questions divided into two parts regarding this new study and its implications:

  • Remmelt Ellen

    1. In your book Quantitive Value, you mention that using long-term average price ratios “might add some marginal predictive ability to price ratios, but not much”. You also mention that “The spread results look almost random to the naked eye”. However, just looking at B/M there seems to be a clear trend in higher returns (13.79% 1-yr -> 15.79% 8-yr, 16.6% equal-weighted for 10-yr in your new study) and wider spreads between value and glamour the more years you use (5.53% 1-yr -> 9.125 8-yr, admittedly 8.9% for 10-yr in your new study). Wouldn’t it be better to look at averaging price ratios over multiple years on a case-by-case basis since their workings are different as well? And can you think of a good reason why B/M may work better for multi-year averages (perhaps to do with accounting methods?). Or could this just be luck (a difficult question)? I also wonder why the seemingly logical idea that normalising earnings will reduce the effect of cyclicality and one-off events (as seen for the Shiller P/E market valuation) and thus increase accuracy and returns, doesn’t seem to work for individual stocks.

  • Yes, QV is still superior. If you monthly rebalance QV you also get better return figures, which are not included in the book. We do not consider momentum in QV.

  • Hi Remmelt,
    The reason we made the claim that long-term averaging adds questionable value relates to the robustness of the effect. For some measures it might add value (B/M), but in other cases it clearly does not. I think it can make sense to take long term averages if there is a viable economic story associated with the differences in performance. For example, it is unclear to me why averaging works for BM, but not EBITDA/TEV. Maybe there is a reason. My guess is it is simply in sample variation. Honestly, the real bottom line from all of this research is simple: buy cheap stuff. Rinse, repeat.
    S/f
    Wes

  • Remmelt Ellen

    Hi Wesley.

    Thanks for taking the time to answer my questions. I had one other part I was trying to post (somehow the comment section had an unstated word limit and only allowed my first three posts to come through) but your answer of the QV method being superior in terms of CAGR (taking the weighting and monthly rebalancing into account for comparison) as well as your risk factors (Sortino, Sharpe & maximum drawdown) for QV in the book being much better means to me that the QV method is a hands-down winner.

    When also taking into account that there is only a 0.26% difference between the 1-year EBIT/TEV and 8-year B/M average and that no sensible reason has been discovered yet for the higher CAGR of the normalised B/M, then I think it also makes sense to stick to using EBIT/TEV for the QV method.

    Thank you for being so open.

  • Great work as always. Any plans to add a cyclically adjusted valuation allocation tool to the site’s toolkit?

  • at some point