Managing The Downside

Today, I am writing about managing the downside since I am increasingly of the opinion that U.S. equity markets are overvalued. In my mind, it’s starting to feel like the dot-com boom times. What causes me to make that statement?

The Shiller PE Ratio, also popularly known as the Cyclically Adjusted PE Ratio or ‘CAPE,’ is above 30. This number has significance. In the modern stock market, which I define as 1970 – Present, the Ratio has only been over 30 during two time periods.

Managing the Downside

Managing the Downside

First, some history on the Shiller PE Ratio. It was during the dot-com boom or some people say bubble that Professor Robert Shiller popularized the Ratio that he had developed along with John Campbell. In his book Irrational Exuberance, published in March 2000, he examined economic bubbles and also argued that equities were overvalued at that moment. The book was prescient, as the long bear market after the long run up in stocks started about then.

The first time the Shiller PE Ratio went over 30 was during the dot-com bubble. On a monthly basis, the Ratio went over 30 in June 1997. The Ratio then went over 40 in January 1999. It peaked in the December 1999 and January 2000 time frame. The Ratio bottomed out at about 21.3 in March 2003.

Now, fast forward to 2020. The Shiller PE Ratio went over 30 in August 2020, and has been there since then. It is interesting to note that the Ratio went over 30 in 1929, before one of the most brutal bear markets. You can scroll down to the bottom this post to see the Shiller PE Ratio over time. 

Shiller PE Ratio for Managing the Downside?

So, based on the above, it seems like the Shiller PE Ratio can be used to predict bear markets and for managing the downside. If you believe that the Shiller PE Ratio is predictive based on past history, then it would be time to lighten up on equities and possibly increase allocation to other asset classes. This would be managing the downside. Yet, is this a reasonable expectation and response by investors? Is it really that simple? Not really.

Managing the Downside is Difficult Based on Historical Data

Some investors and academics do not view the Shiller PE Ratio as predictive. For one, the average has been trending up over the years. The average over the past 100 years is roughly 17.7. The average over the past 50 years is about 20.5. The average since 1989 has been about 25.9. So, if the Shiller PE Ratio’s average is in fact moving upward, then using historical data may not be sensible for managing the downside on equities.

That said, there seems to be a trend between the Shiller PE Ratio and annualized inflation-adjusted or real returns in future years. The graph below is from a study by Star Capital that shows an inverse relationship between the Shiller PE Ratio and real returns in the subsequent 10 – 15-year time periods. Lower values for the Ratio indicate higher returns, and vice versa. This study uses all data for the S&P 500 going back to 1881.

Granted, there is a lot of variability in the data, but the trend is unmistakable. However, there are some discrepancies that make using the Ratio problematic in my opinion. Both Sweden and Denmark have relatively high returns even at a CAPE Ratio of 30 or more. The R2 value, though, is low, meaning that the relationship is not truly predictive. Next, a study by Vanguard concluded that only 43% of returns were predicted by the CAPE Ratio from 1926 – 2011.

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