Swedroe: Using Valuation Metrics

April 24, 2019

Timing The Market Using The CAPE 10

While valuations provide information on future returns, research has found they do not provide information that allows investors to profitably time the market. For example, Cliff Asness, Swati Chandra, Antti Ilmanen and Ronen Israel, authors of the study “Contrarian Factor Timing Is Deceptively Difficult,” which appeared in the 2017 Special Issue of The Journal of Portfolio Management, found “lackluster results” when investigating the impact of value timing (in other words, whether dynamic allocations can improve the performance of a diversified, multistyle portfolio). They write: “Strategic diversification turns out to be a tough benchmark to beat.”

Despite the evidence, many investors ignore the findings and try to use CAPE 10 valuations to time markets. They might shift from stocks to bonds when the CAPE 10 is above its long-term average, and shift from U.S. to international when international valuations are lower (as they have been for a number of years now).

As we just discussed, this has not worked well. However, blaming the CAPE 10 for its failure as a timing tool is like blaming the fork for its failure as a useful tool to eat soup. It is not intended to be used to time markets, only to forecast mean expected returns.

Consider the following example. As of December 2018, the CAPE 10 earnings yields (which provide the best estimate of future real returns) was 3.6% for the U.S., 5.8% for developed non-U.S. markets, and 7.3% for emerging markets. Some investors take this to mean you should underweight U.S. stocks and overweight emerging markets.

This is the wrong use of the CAPE 10 for the simple reason that doing so ignores risk. It’s the equivalent of saying junk bonds with higher yields are better investments than U.S. Treasury bonds with lower yields. The information provided is that investors believe that international stocks are riskier and thus have higher expected returns as compensation for that risk.

It’s important to always keep in mind that the efficiency of the markets means that all risky assets should have similar risk-adjusted returns. Thus, your starting point when determining your asset allocation should be the global market capitalization, which is currently about one-half U.S., three-eighths developed non-U.S. and one-eighth emerging markets. Having set your asset allocation, you should stick with it, rebalancing as needed.


The bottom line is that the CAPE 10 provides us with valuable information (as do other current valuation metrics). However, it’s important that the information be used in the right way, as misusing it can lead to bad outcomes and the failure of plans.

You should not use a valuation metric in a deterministic way (“I’m going to earn X%”). Instead, the forecast should only be used in a probabilistic manner. And you should not use valuations to time the market, meaning shifting allocations toward higher expected returning assets.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

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