September 24, 2013

CAPE Crusaders?

In their newest paper, "On the Performance of Cyclically Adjusted Performance Measures," Gray and Vogel challenge the popular belief that the Schiller P/E or Cyclically Adjusted Price Earnings (CAPE) ratio is the best way to look at value. 

CAPE sounds intuitively appealing in that it inflation adjusts and averages earnings across a 10-year business cycle. Gray and Vogel take the Schiller P/E one step further and examine the 10-year inflation adjusted earnings concept with respect to other valuation metrics as well. Here is what they look at:

 10-year average real earnings to market capitalization (CA-EM)
10-year average real book values to market capitalization (CA-BM)
10-year average real earnings before interest, taxes, depreciation, and amortization to total enterprise value (CA-EBITDA/TEV)
 10-year average real free cash flow to total enterprise value (CA-FCF/TEV)
 10-year average real free gross profits to total enterprise value (CA-GP/TEV)

Using NYSE, AMEX, and NASDAQ large and mid-cap data from July 1973 through December 2012, Gray and Vogel find that CA-BM was the best cyclically adjusted valuation metric relative to other valuation metrics. An annually rebalanced equal-weight portfolio of high CA-BM stocks earned 16.6 percent a year and generated the highest Sharpe (.64) and Sortino (.85) ratio among all cyclically adjusted metrics tested. Book-to-market as a valuation measure was popularized by Fama and French in the early1990's. While CA-BM is the marginal top performer over the past 40 years, all cyclically adjusted value measures have outperformed market benchmarks by large margins. Employing monthly rebalancing enhances the performance of all valuation measures. For example, the CA-BM strategy goes from a 16.6 percent compound annual growth rate (CAGR) to a 19.3 percent CAGR.

Last month, our post called Momentum Combinations showed how we can use momentum in different ways to customize portfolios and enhance performance. The Gray/Vogel dynamic duo also looks at integrating momentum with cyclically adjusted valuation measures to enhance returns. Using monthly-rebalanced portfolios, our anti-CAPE crusaders split each valuation decile into high and low momentum. Employing this additional momentum screen adds at least 100 basis points in return while decreasing maximum drawdowns modestly across the different valuation metrics. Holy Momentum, Batman!