flation-adjusted earnings from the previous 10 years. This measurement is also known as the cyclically adjusted PE ratio (CAPEratio), or P/E 10.
Using 10 years of earnings allows movements in price to play their important role in market cycles. After price has fallen but before earnings have recovered is the best time to invest. The ttm P/E ratio will still look bad, but the P/E 10 will be signaling a buy. Similarly, when the markets are doing well and the last year of earnings make it look like P/E ttm ratios are attractive, the P/E 10 will be signaling you to consider trimming stocks that now look expensive.
In his book “Irrational Exuberance,” Shiller shows that P/E 10 is correlated to the subsequent 20-year annualized return after inflation. A low P/E bodes well for the next 20 years of investing, whereas a higher P/E 10 suggests a lower expected return.
But even if the P/E 10 suggests a lower expected return, it is still appropriate to be invested in the markets. Even a lower expected return is usually sufficient to justify staying invested. Jumping in and out of the markets is not a good investment strategy.
Additionally, the expected return is a 20-year expected return. You cannot justify jumping in and out of the markets based on a 20-year expected return. And finally, average P/E ratios drift based on several factors that have not been modeled in a well-defined system or formula.
The P/E 10 can suggest the proximity of specific indexes or investments to the forward-looking efficient frontier. If P/E 10 is relatively low for an index or investment, it suggests it is closer to the efficient frontier and overweighting it may boost returns going forward. But if P/E is at historical highs, underweighting or lightening up on that particular index investment may lower volatility or downside risk. You can also use the relative ratio between two P/E 10 ratios to suggest that one asset class may be overvalued while another may be inexpensive.
The movements suggested by this approach are small and gradual. This is a much different approach than stock picking or market timing. Indexing is based on the idea that fees matter, whereas this strategy is based on the idea that price matters. And when price gets ahead of what is justified by the past 10 years of inflation-adjusted earnings, then perhaps the exuberance is excessive.
Next week we look at how to use the P/E 10 to add a component of dynamic asset allocation to our static asset allocation model and boost returns even further.
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