Article published by José Alberto León Alonso on 10/27/13 in Diario de Avisos.
Did Robert Shiller find the investor's philosopher's stone? Did you find that investment method capable of transmuting our vulgar savings into pure gold?
Not much either. Robert Shiller, recently awarded the Nobel Prize in Economics, became famous for warning against the irrational exuberance of bubbles and being able to detect them. He based his arguments largely around his own indicator, the CAPE (Cyclically Adjusted Price Earnings or cyclically adjusted price-earnings ratio). Instead of comparing stock prices to their most recent earnings, as the P/E does (P/E or price-earnings ratio), he compared them to their average earnings over the previous decade, because earnings over the past year could be very volatile. By comparing the CAPE at any time with the historical average, undervalued or overvalued values could be detected. This adjustment revealed that the American stock market in 2000 was more overvalued than at any time in its history – including 1929, before the Stock Market Crash. Largely thanks to this success, CAPE is an increasingly used indicator. It was a breakthrough in the imprecise science of market valuation. It is a very good indicator pointing out bubbles, moments of extreme overvaluation, but the problem is that it does not indicate how long the overvaluation will last, so it does not help to choose the moment to enter or exit the market. So CAPE is not the philosopher's stone of investment. After all, between the time Shiller predicted the dot-com bubble would burst and the time it did so, more than four years (1996 to 2000) passed in which the market rose an additional 70%, and those who heeded this prediction missed out on a tidy profit.
What does the CAPE tell us about current prices on the stock markets? Well, if we look at the American stock market, as shown in the graph, the current CAPE is 24.4, somewhat lower than the level prior to the stock market crisis. Subprime lending of 2007 (27.3), substantially below the figures before the crash of 1929 (32.6) and well below the crash of dotcoms in 2000 (where it exceeded the figure of 44). The American market exceeds its average CAPE by 48%, which is 16.5. Does this mean that the American stock market will fall by 50% in a short time? Nothing of the sort. It can continue to rise for several more years and does not have to fall to the average but less (or more), as has happened in the past, but whenever the CAPE of the United States has been greater than 22, the real return in the following 20 years has been negative. So I warn sailors for those who have invested in the American stock market. It cannot be guaranteed that there is a bubble in the American stock market, but it is dangerously close to it. And the rest of the bags? Well, the CAPE of the Greek stock market is less than 3, that of the Irish stock market is less than 7, and that of the Italian stock market is less than 10, although the considerable risk of investing in any of them must be taken into account, which must also be assessed. The CAPE of the Spanish IBEX35 is currently around 10.2, and its historical average is above 17, so it seems cheap even after having risen 20% between September and October, but it is no longer the bargain it was just a couple of months ago.
I mentioned the last week that only 5% of the funds outperform the market in the long term, so for the small investor the conclusion is simple: if they cannot outperform the market, it is best to buy it, investing their savings in index funds that replicate the stock indices and thus beat 95% of the “expert” managers. The way to link this advice with Shiller's “bubble detector” is to buy index funds from countries with CAPE less than 10, whose average profitability historically exceeds 10% annually, and think about selling when they exceed 20. This is a long-term strategy and involves holding the values for at least a decade. Ideal for savings towards retirement. Given that buying at a certain time with a single large outlay means risking losing the bullish pull (which we already saw has just generated increases of 20% in a month and a half), it is advisable to make small periodic contributions, compensating between the good and bad moments to buy, and reevaluate once a year through the CAPE in which indices you invest. It's not the philosopher's stone, but it works.
