Robert Shiller has discovered a backward looking metric, which he calls Excess CAPE Yield (ECY), that shows a correlation with future returns. He discusses it in a blog post (https://www.project-syndicate.org/commentary/making-sense-of-soaring-stock-prices-by-robert-j-shiller-et-al-2020-11), but doesn't go into that much detail. He does share the underlying data on-line.
Essentially, ECY measures how desirable stocks are compared to bonds, in terms of expected yields. Larger numbers are better for stocks, and ECY, as of March 2021, is 3.02%. I set out to determine if 3.02% is a "good" number or not.
More specifically, ECY = 1/CAPE - (GS10 - inflation)
CAPE = Cyclically adjusted price earnings ratio = S&P real price / (average real earnings from last ten years)
GS10 is the ten year US treasury yield.
Inflation is measured over the last ten years.
See https://docs.google.com/spreadsheets/d/126BtxbKgmsIQrTPLMqQ0bZmkDU7unx1s3q9O2AzgBU4/edit?usp=sharing -> Charts. The first figure shows ECY on the x-axis, and subsequent 10 year annualized excess return on the y-axis. Visually, there is a correlation that starts about 1915. The next two plots show the correlation more explicitly, first for 1881 - 2011, and then for 1915 - 2011. The second plot is cleaner.
I then did some back testing and experimenting, which is in the Data tab of the google doc. I found the highest return with the rule that stocks are more desirable if ECY from 3 months ago > 2.0%.
If I move a maximum of 1/12th of my portfolio each month (turning over the whole portfolio in a year) I get an annualized return of 8.73% from 1915 to 2021, compared to 6.78% for stocks alone.
Conclusions
- In January, ECY was 3.77%, which is significantly greater than 2.0% so now is not the time to switch to bonds.
- It is rare to get a signal to switch to bonds, and the signal takes a long time to solidify, but that signal should not be ignored.
Warnings
- Past performance is no guarantee of future results. All back testing requires diligence about when and how past rules may break down in the future.
- I don't take into account taxes or other transaction costs.
- I used 10-year treasuries and the S&P 500 as my benchmarks because they are both available all the way back to 1871, not because I think they are optimal investments.
Submitted March 27, 2021 at 11:57PM by Kaawumba https://ift.tt/3w57wOn
