As broad market indices such as the S&P 500 have set new record highs in recent weeks, many investors have become apprehensive. They fear another major decline is likely to occur and are eager to find strategies that promise to avoid the pain of an extended downturn while preserving the opportunity to profit in up markets. One approach that has attracted considerable attention in recent years is adjusting investments based on the CAPE ratio–the Cyclically Adjusted Price / Earnings ratio.

Developed by Robert Shiller of Yale University and John Campbell of Harvard University, the CAPE ratio seeks to provide a road map of stock market valuation by comparing current prices to average inflation-adjusted earnings over the previous 10 years.1 The idea is to smooth out the peaks and valleys of the business cycle and arrive at a more stable measure of corporate earning power. Shiller suggests that investors can improve their portfolio performance relative to a static equity allocation by overweighting stocks during periods of low valuation and underweighting stocks during periods of high valuation.

A CAPE-based strategy has the virtue of using clearly defined quantitative measures rather than vague assessments of investor exuberance or despair. From January 1926 through December 2024, the CAPE ratio has ranged from a low of 5.57 in June 1932 to 44.20 in December 1999, with an average of 18.94.

Using the CAPE ratio might appear to offer a sensible way to improve portfolio results by periodically adjusting equity exposure, and many financial writers have focused on this methodology in recent years. As an example, a bloomberg writer in 2017 observed, "Something happened in the stock market this week that has only occurred twice since 1871: Robert Shiller's favorite valuation method for the S&P 500, the cyclically adjusted price-to-earnings ratio, reached 30. So, is it time to worry?"2

The only other times in history when the CAPE ratio reached 30 were in 1929 and 2000, right before massive market crashes. So it made sense that some investors were worried about the stock market being overvalued. But since 2017, the S&P 500 is up nearly 170%, good enough for annual gains of roughly 14% per year.

The challenge of profiting from CAPE measures or any other quantitative indicator is to come up with a trading rule to identify the correct time to underweight or overweight stocks. It is not enough to know that stocks are above or below their long-run average valuation. How far above average should the indicator be before investors should reduce equity exposure? And at what point will stocks be sufficiently attractive for repurchase–below average? Average? Slightly above average? It may be easy to find rules that have worked in the past, but much more difficult to achieve success following the same rule in the future.

This implementation challenge appears to be the Achilles' heel of timing-based strategies. A study in 2013 by professors at the London Business School applied CAPE ratios to time market entry and exit points. "Sadly," they concluded, "we learn far less from valuation ratios about how to make profits in the future than about how we might have profited in the past."3

As an example of the potential difficulty, consider the CAPE data as of year-end 1996. The CAPE ratio stood at 27.72, 82% above its long-run average of 15.23 at that point. Federal Reserve Chairman Alan Greenspan had delivered his much-discussed "irrational exuberance" speech just three weeks earlier. The last time the CAPE ratio had flirted with this number was October 1929; the CAPE was at 28.96 as stock prices were about to head over the cliff. It seems plausible that followers of the CAPE strategy would have been easily persuaded that investing at year-end 1996 would be a painful experience.

The actual result was more cheerful. The next three years were especially rewarding, with total return of over 107% for the S&P 500 Index. For the period January 1997 – June 2014, the annualized return for the S&P 500 Index was 7.67%, compared to 2.42% for one-month US Treasury bills. Stock returns were modestly below their long-run average for this period, but the equity premium was still strongly positive.

By comparison, a timing strategy over the same period that was fully invested in stocks only during periods when the CAPE ratio was below its long-run average produced an annualized return of 3.09%. All timing strategies face a fundamental problem: Since markets have generally gone up more often than they have gone down in the last 97 years, avoiding losses in a down market runs the risk of avoiding even heftier gains associated with an up market.

A successful timing strategy is the fountain of youth of the investment world. For decades, financial researchers have explored dozens of quantitative indicators as well as various measures of investor sentiment in an effort to discover the ones with predictive value. The performance record of professional money managers over the past 50 years offers compelling evidence that this effort has failed.

Despite this evidence, the potential rewards of successful market timing are so great that each new generation sees a fresh group of market participants eager to try. Searching for the key to outwitting other investors may be fun for those with a sense of adventure and time on their hands. For those seeking the highest probability of a successful investment experience, maintaining a consistent allocation strategy is likely to be the sounder choice.


1. CAPE data available at http://www.econ.yale.edu/~shiller/data.htm.

2. Ben Carlson, "What to Make of These Twice-in-History S&P 500 Valuations," Bloomberg, March, 2017.

3. John Authers, "Clash of the CAPE Crusaders," Financial Times, September 3, 2013.


About Index Fund Advisors

Index Fund Advisors, Inc. (IFA) is a fee-only advisory and wealth management firm that provides risk-appropriate, returns-optimized, globally-diversified and tax-managed investment strategies with a fiduciary standard of care.

Founded in 1999, IFA is a Registered Investment Adviser with the U.S. Securities and Exchange Commission that provides investment advice to individuals, trusts, corporations, non-profits, and public and private institutions. Based in Irvine, California, IFA manages individual and institutional accounts, including IRA, 401(k), 403(b), profit sharing, pensions, endowments and all other investment accounts. IFA also facilitates IRA rollovers from 401(k)s and 403(b)s.

Learn more about the value of IFA, or Become a Client. To determine your risk capacity, take the Risk Capacity Survey.

SEC registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the adviser has attained a particular level of skill or ability.

About the Author

Weston Wellington

Weston Wellington - VP, Dimensional Fund Advisors

Weston Wellington has spent over 40 years in the investment industry. He works closely with professional financial advisors around the world, showing them how a science-based “equilibrium” strategy can possibly improve investment success. Weston majored in history at Yale and has been with Dimensional Fund Advisors since 1995.

Cape Fear
Weston Wellington
Written By Weston Wellington

VP, Dimensional Fund Advisors

IFA's

— Risk Capacity —

Survey

Please estimate when you will need to withdraw 20% of your current portfolio value, such as a need for a house down payment or some other major financial need.

  • Less than 2 years
  • From 2 to 5 years
  • From 5 to 10 years
  • From 15 to 20 years
  • More than 15 years

Find a portfolio that matches your Risk Capacity


The IFA app is free to download and provides simplified access to features and content available on our website and elsewhere. Note that downloading this app does not include access to Index Fund Advisors advisory services.