The Shiller cyclically adjusted price-earnings (CAPE) ratio is typically regarded as a stock market valuation measure. When the CAPE is high stocks are expensive and vice versa. But the CAPE itself is not a good stock market timer. However, it can be indirectly used for market timing by determining a cycle-ID as formulated by Theodore Wong.
Wong used double-leveraged long, inverse-unleveraged short and unleveraged-long synthetic ETFs based on the monthly average of the S&P 500 from 1900 to 2016, and showed very impressive hypothetical returns. My 1950-2016 back-test of the CAPE-cycle-ID model, using just the S&P 500 with dividends and money market funds, showed an annualized return of 11.9% versus 10.4% for buy-and-hold.
The Shiller CAPE can be determined at the end of every month. Inputs are the average value of the S&P 500 index for the month, earnings of the S&P 500, and the consumer price index (CPI). Using the CAPE, I developed a market timer according to a few simple rules.
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The CAPE-Cycle-ID market timer
The construction and rules for my CAPE-cycle-ID model are summarized below. The rules differ from the Wong model only in respect to the investment choices and trading times.
- A primary oscillator is constructed from the year-over-year rate-of-change of the CAPE (YoY-ROC-CAPE).
- The exponential moving average (EMA) of the YoY-ROC-CAPE is then calculated with a smoothing factor of 0.20 (EMA-YoY-ROC-CAPE).
- A secondary indicator is calculated from the month-over-month change of the EMA-YoY-ROC-CAPE (MoM-EMA-YoY-ROC-CAPE).
- Score +1 when the EMA-YoY-ROC-CAPE is greater or equal to -13%, otherwise score -1.
- Score +1 when the MoM-EMA-YoY-ROC-CAPE is greater than zero or when it has a positive slope (i.e. when the current month level is greater than the previous month level), otherwise score -1.
- Sum the scores for each month. Possible combined scores are +2, 0, and -2.
- Invest in the stock market when the combined score is +2 or 0.
- Go to cash or bonds when the combined score is -2.
After a combined score change, trade on the first trading day of the following week.
Shiller CAPE Ratio
By Georg Vrba, read the full article here.