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Alternative Tests of P/E10 Usefulness

Posted in Fundamental Valuation

In response to the market timing backtest in "Usefulness of P/E10 as Stock Market Return Predictor", subscribers suggested two modifications for exploiting P/E10 (or Cyclically Adjusted Price-Earnings ratio, CAPE):

  1. Instead of binary signals that buy (sell) stocks when P/E10 crosses below (above) its historical average, use a scaled allocation to stocks that considers how far P/E10 is from average.
  2. Instead of holding cash when not in stocks, hold 10-year government bonds (with risk of capital loss on the bonds).

To investigate, we backtest these modifications. Using monthly data from Robert Shiller, including S&P Composite Index level, associated dividends, 10-year government bond yields and values of P/E10 during January 1871 through March 2017, we find that:

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