Shiller Cyclically Adjusted PE 10 Stock Market Timing Strategy

This strategy is a market timing strategy based on Robert Shiller's 10 Year Cyclically Adjusted Price Earing Ratio as a long term stock market timing indicator.

Yale Professor Robert Shiller has devised and maintained a so called ‘Cyclically Adjusted Price Earning’ ratio (CAPE10) as an alternative to the popular PE ratio to value the US stock market. CAPE10 is defined as the ratio of price to the average of last 10 year trailing S&P 500 annual earnings. In his now famous book titled as “Irrational Exuberance”, Shiller popularized this ratio as a long term stock market valuation metric.  For example,  on Friday October 23, 2009, the current CAPE10 was 24.08 while the long term average CAPE10 (since year 1881) was 16.34. This implies that the US stock market was 35% over valued on that day. 

It is interesting to examine how effective using such a metric as a long term stock market timing indicator. Similar to the Warren Buffett’s stock market metric, ValidFi implements and maintains a live strategy called Shiller Cyclically Adjusted PE 10 Stock Market Timing Strategy. This strategy characterizes the stock market valuation into the following five categories based on the ratio of the current CAPE10 to the long term average CAPE10:

• Significantly Overvalued (SO): such as if the ratio >= 150%
• Modestly Overvalued (MO): such as if   117% <=  ratio < 150%
• Fairly Valued (FV): such as if 83% <= ratio < 117%
• Modestly Undervalued (MU): such as if 67% <= ratio < 83%
• Significantly Undervalued (SU): such as if ratio < 67%

These five categories are determined by four valuation parameters (such as 150%, 117%, 83% and 67% in the above). At each rebalancing (adjusting) period (such as weekly or monthly), the strategy decides at what region the US stock market valuation is and then does the following rebalancing:

• SO: 0% in stock, 100% in cash.
• MO: 25% in stock, 75% in cash.
• FV: 50% in stock, 50% in cash
• MU: 75% in stock, 25% in cash
• SU: 100% in stock, 0% in cash

The stock market exposure is through buying Wilshire 5000 total return index (^DWC) or it could be set by users. Users could adjust the valuation parameters to get an effect like only buying at significantly undervalued (SU) level and selling at significantly overvalued (SO) level. Some of model portfolios of this strategy are:

• SO: >=150%, MO: [117%, 150%), FV: [83%, 117%), MU: [67%, 83%), SU: <67%
• SO: >=150%, MO, FV, MU: [67%, 150%), SU: <67%

Similar Strategies in ValiFi:

• ValidFi 360 Degree Market View: maintains up to date data for Shiller's CAPE10, Warren Buffett's GNP ratio, John Hussman's Peak PE and other indicators.
• Warren Buffett Total Stock Market Value to GNP Ratio Strategy: using Warren Buffett's GNP/GDP metric as a long term stock market timing indicator.
  
• Market Timing Rule with Short Term Interest Rate: using the short-term interest rates as an indicator 
• Market Timing Rule with Maturity Spread: using the spread of long-term and short-term interest rates as an indicator 
• SMA Timing Method proposed by Faber: using the SMA of the target asset as an indicator
• High Yield Bond Timing Strategy: using  trend  triggers (percentages from recent high or recent low) of the asset price for buy and sell decisions
• The 125 05 Timing Model of High Yield Bond Strategy by Gerald Appel: using  predifined trend  triggers (percentages from recent high or recent low) of the asset price for buy and sell decisions
• Market Timing Rule with Long Term Interest Rate: using long-term interest rate as an indicator
• Market Timing Rule with Earning to Price Ratio: using the E/P ratio as an indicator
• Market Timing Rule with Dividend Yield: using the dividend yield as an indicator
• Market Timing rule with Implied Volatility Index : using the implied volatility index  as an indicator  
• Market Timing Rule with Bond-Equity Yield Ratio : using the bond-equity yield ratio as an indicator 
• Market Timing Rule with Dividend Payout Ratio : using the dividend payout ratio as an indicator 
• Market Timing Rule with Credit Spread :  using the credit spread as an indicator
• Market Timing Rule with Put/Call Ratio:  using the put/call ratio as an indicator
• Learning Market Timing Rule: following the most profitable rule of the above simple market rules in each period 
• Voting Market Timing Rule : Switching the position if a certain percentage of the above simple market timing rules intends to do so.

See Also

• Robert J. Shiller, "Irrational Exuberance", Broadway, April 10, 2001.
• Shiller and Tobin's Q,  http://www.smithers.co.uk.
• Warren Buffett and Carol Loomis, "Warren Buffett On The Stock Market", Fortune, December 10, 2001.
• John Hussman, "The Likely Range of Market Returns in the Coming Decade", Hussman's Weekly Commentaries, February 22, 2005.
• Gurufocus, "Where Are We with Market Valuations?", gurufocus.com.