I've read much about investing, how nothing is predictable and how even the best financial manger probably wont due much better than an indexed fund. I remember reading this article that described a way of determining if the market was overpriced using the PE ratio, and moving your money out of the market when certain key indictors crossed each other. When they did this regression over a number of years it outperformed the method of just keeping all your money invested. Now I understand that there are many other factors in the market than the PE ratio, but I'm wondering if using this basis is a good model for someone who has the majority of their investments in mutual funds. Should I just be holding my money in the market regardless of what happens? or should I be preemptively moving money out of stocks when the market seems overpriced ( presumably this is what mutual fund mangers are doing )

  • The article paragraph "A buy-and-hold investment in the market for the whole 83-year period earned ..." is mathematically dubious, since it doesn't say what you do with the money with the other 35 years. After all, the buy-and-hold investor still wound up with 10,382 whereas the trader only had 9,440. – RonJohn Jan 1 '18 at 22:40
  • Also, what about the succeeding 14 years? – RonJohn Jan 1 '18 at 22:41
  • @RonJohn I see your point but 91% of the gains in 54% of the time, seems pretty enticing, for the remainder, I don't know CD's ,bond fund? obviously I'm no expert, but I am intrigued by it, and I would give up that 9 percent to have all that liquidity – user379468 Jan 1 '18 at 23:00
  • But it's not 54% of the time (the 45 years from 1920 to 1965). It's 54% of the years between 1920 and 2003) invested in the market, which is a completely "thing". – RonJohn Jan 1 '18 at 23:03

Great question - one could write an entire book answering it. The P/E ratio is a reasonable (I don't agree with the subjective term "good") indicator of whether a particular company is over or undervalued compared to its past performance. Remember that P/E is a ratio - you get the same P/E value if the stock price doubles and the earnings also double, so it only tells you so much about the financial health of a company. Generally, if the P/E of a company is higher than its typical (mean reverting) value, then more people are interested in the company stock (higher demand drives up price; earnings being constant this means P/E goes up). But it could also mean that earnings have decreased and the price is constant, which also results in a higher P/E ratio.

I find the SMA (simple moving average) time constants somewhat arbitrary, but Professor Shiller had to pick something. All it really says is that company prices oscillate over time, and on timescales that are unique to a particular company or industry. Crossings like these are more often than not good indicators. However, as to your direct question about whether you should use them to "get in or get out" of a particular market, that depends on your time horizon and risk tolerance. Since no one can predict the future, who's to say that a market dip will last one week, one year, or one decade or how large the dip is. Whether to sell and horde cash during a dip or "ride it out" is completely an individual decision based on risk tolerance and time horizon. For example, if you need a particular stock in order to pay your mortgage next month (a short time horizon where risks need to be kept small), then use a sell indicator and get out. On the other hand, if you have an investment that you don't need to touch for 20 years, then riding through the dip is a reasonable strategy.

Professor Shiller's analysis is sound, but I advise some skepticism in applying the results to future markets. Using data from the past (where a certain set of market dynamics and government policies were in place) may not apply to future markets. Think of how the 2017 tax change is going to affect P/E ratios. Are they going up (further from their mean values) because price will accelerate based on expectations of a better business climate, or will they go down because earnings will advance? Tough call. Could go either way.

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