God is a Capitalist

Wednesday, November 12, 2014

CAPE Fear

I recently finished Meban Faber's book, Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market, and found it to agree very well with the ABCT Investing philosophy. Faber is a co-founder and Chief Investment Office of Cambria Investment Management.

Faber aimed his book at the majority of individual investors who try to time the stock market on their own. Studies of the flow of money into and out of mutual funds prove that most individual investors wait to enter the stock market until it has reached the peak of a cycle and then sell when it is near the bottom of a collapse. In spite of this, most people think they are good investors. It's all part of the syndrome in which most people think they are better looking and more intelligent than average.



Faber's favorite tool for helping individual investors break out of their losing habits is Robert Shiller's CAPE index. CAPE stands for Cyclically Adjusted Price Earnings ratio. Shiller won the Nobel Prize in 2013, but he and John Campbell wrote a paper about CAPE in 1988. Shiller got the idea for CAPE from the great investment analyst Benjamin Graham who championed value investing. Graham recommended calculating the PE ratio of stocks by using an average of seven years of earnings instead of the latest year or trying to guess next year's earnings as so many analysts do. For some reason, Shiller chose to use ten years of earnings. Faber shows in his book that Graham's seven years actually works a little better than ten years. Also, Shiller adjusts earnings for inflation.

The mean of the CAPE for the S&P 500 since 1871 is 16.47 while the median is 15.88. The CAPE currently stands at 26.51. When the CAPE peaks, the returns for the succeeding ten years will be the worst; but when the index bottoms, the next ten years will produce the best returns. Faber studied the market beginning in 1881 and found that the ten worst years to invest were those in which the CAPE registered an average of 23.31. The next ten-year returns came in at -3.30% per year on average. The best ten years to invest were when CAPE averaged 10.92, which produced a ten-year average return of 16.10%.

Faber doesn't just promote the CAPE. He listens to critics and responds to them as well as compares the index to about a dozen other measures of value. He concludes that all of them will serve the investor well. CAPE appears to work very much like the Misesian Index developed by Mark Spitznagel in The Dao of Capital: Austrian Investing in a Distorted World.

The general idea of these measures of value in the market is for the investor to choose cut off points above and below the mean or median. I recommend using the median because the high valuations in the stock market during the dot.com bubble of the late 1990s raises the mean too much. Outliers such as those don't distort the median. Where an investor draws those line will depend on how conservative she wants to be.

Assume she draws the upper line at five points above and below the median, or about 21 and 11. That investor should only buy stocks when the CAPE is below 11, accumulate cash when it is between 11 and 21 and sell when CAPE rises above 21. The approach is similar to that of Ben Stein in Yes, You Can Time the Market! in which Stein uses a long run moving average. And it's similar to my philosophy of using the Austrian business-cycle theory to time buying and selling.

Of course, the CAPE and all other measures of value are very high at the moment and investors should consider cash or bonds. But some of the more interesting chapters in Faber's book are those on using the CAPE to guide investment in other countries. He analyzed the markets in 44 nations and found that using CAPE as a guide to investing in the markets of those countries rewarded the investor with returns far above average. But keep in mind that the nations with the lowest CAPE when Faber wrote the book last year were Greece, Ireland, Argentina and Russia. As Faber points out, investing in those nations would have taken courage.

Instead of always buying and holding stocks as mainstream finance recommends, investors will earn far greater returns on their investment by mechanically following an index like the CAPE. With CAPE valuations of many nations on the internet, investors have an additional option of investing in other countries when the the US market is too expensive. In fact, this CAPE web site, http://www.caperatio.com/, offers an online calculator for individual stocks.
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