In a recent study, market timing based on Robert Shiller’s well-known Cyclically Adjusted Price-to-Earnings (CAPE) ratio failed to produce market-beating returns. Here I offer an explanation of why this doesn’t work.
Shiller’s CAPE is one way to try to measure whether stocks are currently over- or under-valued. If CAPE gives correct results, you might think it’s self-evident that getting out of the market when stocks are overvalued would be a good idea. Based on this reasoning, the study results seem to imply that CAPE is not a good valuation measure, but this isn’t necessarily correct.
Even if CAPE is completely accurate, it still isn’t necessarily useful for market timing. The problem is that it takes time for stock prices to readjust. Suppose that CAPE says prices are 10% too high. If the market reacted quickly, then next year’s returns would be 10% lower than normal. But prices don’t react this quickly.
Suppose that it takes 10 years for stock prices to adjust and bring the CAPE measure back to “normal.” This means that over those 10 years, returns were 1% lower per year than they would have been without this adjustment. So, if you normally expect to earn inflation+5%, then when CAPE says stocks are overvalued by 10% you might expect only inflation+4% for the next decade.
However, inflation+4% is still better than what you could expect from bonds, real estate, or any other common investment category. So, you can be exactly right about stocks being overvalued but still not be able to use this knowledge to make any extra money. Being out of the stock market is a bad idea more often than not.