Is Valuation A Good Market-Timing Indicator? | Tactical Investment Insight 09-10-2014

After 5 years of a bull market, US Equities hit record highs again in the end of August as the S&P 500 index continues trading above the 2,000 level. As stock prices soar higher, their price/earnings ratios increase, making the stocks more “expensive.” Many analysts are currently paying more attention on “Cyclically-Adjusted Price/Earnings Ratio” or CAPE, proposed by Yale Professor Robert Shiller, rather than the trailing twelve-month P/E ratio, which is currently 19.80. (The mean is 15.52.)

Using average earnings over a 10-year time frame, the CAPE is currently 26.48 – which indicates that stocks are almost as expensive as they were in 2007 – just before the financial crisis. The average is 16.55 and the standard deviation is 6.57. As a result of comparing the current Shiller CAPE to the long term mean, we can see that the market is currently overvalued by approximately 60%. It is traded close to the level on “Black Tuesday” in 1929 when the stock market crashed (see Figure One).

 Figure One: Shiller PE(CAPE)

Source: Multpl.com

Investors are wondering how long the market can stay overvalued and when the market will turn. As a tactical investment manager, we are asking a similar question:  when the markets become overvalued, shall we be out of markets? In other words, is valuation a good timing indicator?

To answer the question, I have tested a simple trading strategy based on CAPE as follows: when CAPE > 23 ( = mean + one standard deviation) , investing in cash, otherwise, investing in S&P index. That means, when the market is overvalued by more than one standard deviation above the long-term mean, we are out of the market. The back test results are summarized in Table One.

Table One: Timing Strategy Back Test Results

Data Sources: Multple.com, FRED. Testing period: 02/1881 – 08/2014.

The timing strategy reduced the average annual return by 60 basis points. The standard deviation and maximum peak-to-valley drawdowns improved slightly. However, the strategy did not avoid the big stock market downturns during the great depression in  and the most recent financial crisis in 2008. Although the strategy avoided the deep losses from Tech bubbles, it missed the strong bull market in the late 90s (See Figure Two). Overall, the results are not satisfactory. The minor improvements of the risk profile with reduced expected return are not significant enough to be an effective investment strategy.

In summary, market timing using valuation alone is not an attractive strategy. Investors will need to consider other economic and technical factors in order to develop a more robust market timing strategy.

Figure Two: Valuation-Based Trading Strategy