In a never-ending battle of bull and bear sentiment, the financial press serves its perennial article citing high S&P 500 valuations, using the oft-cited CAPE ratio (or Shiller P/E ratio) as a US equities predictive analytic. While quite effective on a 20-year time horizon, this measure becomes an easy one to ignore due to long periods when the indicator signals over-valuation. This author would contend that a combined analytic using the CAPE ratio with more subtle credit / labor market indicators would prove far more useful for investors.
Background on the CAPE Ratio
Made famous by Nobel laureate Bob Shiller in an academic paper (and later in his book “Irrational Exbuerance”), the measure was originally shown to provide the investor with a faithful leading indicator (from 1881 until today) of return on S&P 500 equities over a 20-year time horizon. If only the most tenacious investors were that patient.
For those who would time the US market cycle in avoiding a market correction or crash, the CAPE has frequently been cited by pundits and press as a warning signal for an over-heated market & near-term reckoning in inflated stock prices (Barron’s – Stock’s Are Overvalued).
And listening to such warnings has frequently proven poor advice. For those with an investment time horizon less than 20 years (anyone?), this measure begins to sound like “the boy who cried wolf”.
A Better Predictive Analytic for US Equities Using the CAPE Ratio
Like many hotly debated matters in the press, simple yet subtle answers light the path forward. When paired with certain leading indicators for the US market cycle, the CAPE ratio appears very reasonable in predicting S&P 500 return over a shorter time-frame.
In the charts below, I offer a three-dimensional look at 12-month forward S&P 500 return versus the CAPE ratio & a secondary indicator (in a given week). The data presented spans 30 years (1985 – 2015). The data series are left raw (not transformed) to allow for interpretability through visual inspection. The secondary indicators offer information on US labor or credit market conditions (different from the CAPE in assessing asset valuation conditions). On several charts, the clustering of indicator values are significant and warrant notice.
Several interesting decision rules can be conceived and/or seen by the human eye to predict 12-month forward S&P 500 return from the data presented.