And as Estrada noted: “The evidence also seems to suggest that such rules would have been nearly impossible to determine ex-ante, in addition to being psychologically very difficult to implement. The evidence in this article adds to the doubts about the past and future success of valuation-based strategies.”
Estrada also warned that it’s always possible to look back, manipulate the data enough, and “find some thresholds for the multiples that would have produced valuable signals and successful strategies.”
That said, there’s an important message here that should not be lost. As Estrada notes: “The fact that multiples are not helpful for asset allocation should not be interpreted as suggesting that they are not helpful for forecasting long-term returns. In fact, the evidence … suggests that multiples do have predictive power in the long term.” And that is why my firm uses the CAPE 10 in providing our estimate of future long-term returns.
There’s one more important point I would like to add regarding the use of metrics like the CAPE 10 to time the market instead of using them only for forecasting long-term expected returns, as we do. It’s that there is a very good reason TAA strategies based on valuation metrics are not likely to work.
Even if multiples are relatively high, generally an equity risk premium is still at work (although there wasn’t one in March 2009 when the D/P and E/P were both well below the yield on virtually riskless 10-year TIPS, a pretty good sign that there was a bubble). And investors reducing their exposure to equities when a premium exists are forgoing that premium.
Ignore The 135-Year Mean
Furthermore, as explained in an article I wrote earlier this year, there are many logical explanations for why using a 135-year mean for the CAPE 10 isn’t appropriate. Using a strategy that relies on a metric reverting to its long-term mean of 16.6 is, in my view, based on bad assumptions. Following is a summary of some key issues from that article.
The fact is that our economy is much less volatile than it was 100 years ago. In addition, the United States was a much less wealthy country 100 years ago; capital was much scarcer, resulting in low valuations. Also, 100 years ago, we didn’t have the Federal Reserve. And there was no SEC, or a Financial Accounting Standards Board, either.