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 Risky CAPE ratios? Keep calm and reduce downside risk

Risky CAPE ratios? Keep calm and reduce downside risk

27-07-2018 | Insight

High CAPE ratio levels do not signify an imminent end to the bull market. But they do sound a note of caution.

  • Pim  van Vliet, PhD
    Pim
    van Vliet, PhD
    Head of Conservative Equities

Speed read

  • High CAPE ratio levels do not imply a correction is imminent 
  • But they do indicate higher downside risk 
  • A ‘conservative’ approach can help reduce such risk 

The cyclically adjusted price-to-earnings ratio, commonly known as the CAPE ratio, recently reached levels seen on the US stock market in 1929, sparking renewed fears that global equity markets could be ripe for a correction. But this may not be the case. As Nobel prize winner Robert Shiller – one of the fathers of the CAPE ratio –  indicated earlier this year, equity markets could remain bullish for years.

The CAPE ratio is a valuation measure of the stock market that can be defined as stock prices divided by the moving average of ten years of earnings per share, adjusted for inflation. It is a widely followed measure, usually applied to broad equity indices to assess whether the market is under- or overvalued.

But a closer look at the relationship between CAPE ratios and equity returns shows that the CAPE ratio is a poor predictor of market performance. An analysis of US stock market data for the period 1929-2018 reveals only a weak negative relationship between the CAPE ratio and the subsequent three-year equity returns adjusted for inflation.

The expected three-year equity returns over the entire sample period is lower when the CAPE ratio is high and, generally speaking, enters negative territory when CAPE ratios are very high (above 30). However, there is also quite some variation in returns, with considerable losses visible for CAPE ratios of around 25, and solid returns for CAPE ratios of around 30.

But while the CAPE ratio may not be a very reliable indicator for predicting market reversals, it can definitely help assess downside risk. Our research shows that higher CAPE ratios are typically followed by periods with higher downside risk, as measured by the lower partial moment (LPM), which is calculated by multiplying the probability and magnitude of an expected loss. This pattern has been visible not just for US equities over the past 90 years but also, more generally, in global developed and emerging stock markets.

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Time for a ‘conservative’ approach?

High CAPE ratios do not, therefore, signify an imminent end to the bull market, but they do sound a note of caution about downside risk. The good news for investors is that they can reduce this risk substantially by tilting their equity portfolios towards low-risk stocks. A simulation using a simple low-risk investment formula, dubbed the ‘Conservative Formula’,1 in a universe of 1,000 large US stocks shows that the risk of losing money can be reduced significantly – even when CAPE ratio levels are high. 

The Conservative Formula divides the investment universe into two equally sized groups based on the historical volatility of returns over a three-year period. Within the group of 500 lower-volatility stocks, it selects the 100 most attractive stocks based on net-payout-yield (NPY) and price momentum. We refer to this defensive equity style as ‘conservative’. 

Our calculations show that using this simple investment formula significantly reduces the chance of losing money on the stock market over 3-, 12-, 36- and 60-month investment horizons. Moreover, the Conservative Formula also proves to be very effective at reducing downside risk, as measured by the LPM, when CAPE ratios are high. For example, the three-year downside risk is reduced significantly, from -15% to -2%, when the CAPE ratio is above 25. Figure 1 shows this reduction of downside risk compared to the broader equity market, across different CAPE ratio ranges. 

Figure 1: Risk reduction of the Conservative formula across CAPE ratio ranges

Source: Robeco, paradoxinvesting.com. Risk = three-year downside risk

As the summer of 2018 begins, equity markets remain at or near all-time highs and volatility is low. This might be a good moment for investors to take a strategic look at their long-term investment portfolio and consider a more ‘conservative’ approach.

1Blitz, D. and Van Vliet, P., ‘The Conservative Formula: Quantitative Investing Made Easy’, March 2018.

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