Today we are introducing a new market timing indicator: Shiller P/E Model.
The Shiller P/E is a valuation measure used to assess the extent to which a broad equity index is undervalued or overvalued. The ratio was popularized by Yale University professor Robert Shiller, who won the Nobel Memorial Prize in Economic Sciences in 2013. The Shiller P/E has attracted a great deal of attention given its effectiveness in signaling broad economic recessions and is alternatively considered a "cyclically adjusted P/E ratio."
Methodology
The Shiller P/E is founded on the work of renowned investors Benjamin Graham and David Dodd in their 1934 investment guide “Security Analysis.” Graham and Dodd recommended using a multiyear five- or 10-year average earnings per share (EPS) to compute P/E ratios to control for cyclical effects.
The numerator of the Shiller P/E is the real Standard & Poor's 500 price index (S&P/TSX in Canada), and the denominator is the moving average of the preceding 10 years of real reported earnings. "Real" indicates that the stock index and earnings are adjusted for inflation using the consumer price index (CPI). The purpose of the 10-year moving average of real reported earnings is to control for business cycle effects on earnings.
Many analysts believe that the Shiller P/E should be considered a mean reverting series. That is, if the mean value of the P/E ratio over a period of years averaged 17 and the current value of the market P/E is 16, then the market would be expected to rise in value until it reverted back to 17.
We have never found this tactic to be terribly effective in that it does not always accurately signal the start and end of recessionary and expansionary periods. Alternatively, we prefer to look for "crossings." That is, we base our buy/sell signals on when the market P/E crosses the Shiller P/E, from below or above. In particular, if the market P/E crosses the Shiller P/E from below, the market has moved into overbought territory and investors should sell. If the market P/E crosses the Shiller P/E from above, then the market has moved into oversold territory and investors should buy. Once a line "crosses," investors should maintain that position until the next crossing. Based on our observations, crossings between the market P/E and Shiller P/E have been extremely effective over the last few decades at signaling the start or end of a recession.
U.S. S&P 500 findings
Figure 1: Shiller P/E and Market P/E, 2012-2016
Interpretation
Investors would have performed very well basing their buy/sell decisions on market P/E - Shiller P/E crossings. The system accurately predicted a strong buyers market in the early to mid-1990s. The model gave a strong sell signal in mid-2001 following the bursting of the tech bubble and the start of a minirecession. This was followed by a strong contrarian buy signal in late 2003. While not timing the inflection points in the stock market perfectly (this indicator does a better job at timing business cycle inflection points), investors buying and selling as prescribed would have still earned sizeable returns. Investors buying in 2003 would not have seen their next sell crossing until the start of 2008 but would have earned exceptional returns over the period if they stayed disciplined and stuck to the strategy. The next buy crossing was not triggered until early 2010 and, as of today, continues to signal "market undervaluation."
Canada S&P/TSX Findings
Figure 2: Shiller P/E and Market P/E, 2012-2016
Interpretation
As in the U.S., investors in Canada would have performed well basing their buy/sell decisions on market P/E - Shiller P/E crossings. The system accurately predicted a strong buyers market in the early to mid-1990s. The model gave its first strong sell signal in April 1998 only to revert back to buy territory the following month. The system continued to provide buy signals up until late 1999, at which time the market P/E crossed the Shiller P/E again from below signaling a sell. A buy crossing was triggered again within a couple of months. This regular crisscrossing of the market P/E and the Shiller P/E is a clear sign of market consolidation. At these times, it is prudent to wait for a clear spread to emerge between P/E lines before buying back into the market: close your positions, take your profits and wait on the sidelines.
After the bursting of the tech bubble, a strong contrarian buy signal was triggered in late 2003. Investors buying in 2003 would have seen their next sell crossing in mid-2009, earning investors exceptional returns over the period. The next buy crossing was triggered in early 2010. A sell was triggered in 2013 and, as of today, continues to signal "market overvaluation."
Stay tuned
Next week we will be discussing our "Contrarian Model," the seventh of our nine market timing indicators.
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