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Is the Market Overvalued or are the Measuring Gauges Broken?

March 8, 2016

by Theodore Wong

Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

It is remarkable that market-top calls have enticed many advisors and analysts to fully embrace the cyclically adjusted price-to-earnings ratio (CAPE) as their crystal ball to foretell the future of the stock market. Such faith, as I will demonstrate, is misguided.

For nearly three decades, the CAPE that professors John Campbell and Robert Shiller created in 1988 and updated in 2015 has been adopted as the scale for measuring market valuations.

This is not surprising. As Figure 1 shows, CAPE has had great foresight for predicting major stock market calamities over the last century. It spiked above 27 only three times, in 1928, 1999 and 2007 (red circles), and all three spikes were followed by historic disasters. The CAPE also reached three minor summits in 1900, 1937 and 1966 (blue circles), which all led to prolonged bear markets. When CAPE hit 27 in 2015 (orange box), even perma-bulls lost confidence in prospective performance.

A hazy crystal ball at best

Despite the mirage of reliability on its surface, advisors need to exercise extreme caution as many CAPE-based research analyses have become unhinged from basic statistical principles. The apparent linkage between valuations levels and the posterior stock returns spurred much research on market forecasts. In performing a 10-year regression on CAPE, one starts with 144 years of Shiller's data. Ten years are used to smooth earnings and ten for forward-return calculations. This leaves 124 years of monthly data, which should be enough to do regression analyses, right?

But consider the fact that regressions are graded by R-squared. R-squared denotes how well the independent variables (e.g., CAPE) explain the dependent ones (e.g., 10-year forward returns). To show just how dubious many of these yardsticks are, Figure 2 is Vanguard's ranking of 15 valuations metrics by their predictive power R-squared. CAPE had the best R-squared, but half of the metrics ranked below simple rainfall as a predictor for stock market returns.