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I believe that this is fundamentally good research. But beware if anyone thinks that you can use this to build a killer investment strategy. If one tests a sim

I believe that this is fundamentally good research. But beware if anyone thinks that you can use this to build a killer investment strategy. If one tests a simple rule, for example "buy when the shiller p/e ratio dips below 15 and sell when it hits 20" then indeed, you would have seen some fantastic results - most obviously in the aftermath of the 2008 financial crisis, when after adjusting for inflation and dividends, you could have bought the S&P500 in Feb 2009 for 887.12 and sold it again in December for 1202.03, realizing a 35% return after inflation). However, you also would have had the patience and determination to ride out some extremely tough times - you'd be long stocks for the 1987 crash, and completely miss out on the pre-2000 tech bubble, for example). You'd also have to ride out some drawdown that would have wiped out 50% of your capital before the eventual recovery. In fact, you'd only have placed six trades in about 125 years -- 1. Buy in April 1882 and sell in 1898, realizing 2.62% annualized, inflation-adjusted return over 16 years. 2. Buy in March 1907 and sell in 1928, realizing 1.01% annualized and inflation-adjusted over 21 years. 3. Buy in Sept 1931 and sell in 1936, realizing 10.1% annualized over five years (this was a great trade, as you bought in the immediate aftermath of the 1929-1930 crash, and just before the recovery of the early 1930s) 4. Buy in Jan 1937 and sell in 1961, realizing 6.79% annualized over 24 years (another great trade, but you would have had to hold your position over the second world war, which included some terrifying drawdowns). 5. Buy in 1973 and sell in 1992, realizing 2% annualized over 19 years. Again, you'd have to suffer losing over half your capital before you eventually came out on top. 6. Buy in Feb 2009 and sell in December the same year, realizing a 35% return in less than a year (the single greatest trade in the strategy's history, perhaps indicating how thoroughly depressed markets were after the 2008 crash).

onebaddude 13y ago
Thanks for this. I think a major flaw with the Shiller P/E is that there is no fundamental reason for choosing 10 years of earnings for the calculation. Why not 7, or 12? When events like 2008 happen, and earnings drop tremendously and temporarily, it puts a serious skew on the metric going forward (until that single year is no longer used in the calculation). It is, however, a useful tool for "guesstimating" whether future stock markets returns will be above or below historical averages.
_airh 13y ago
Where did you get this information from? What tools / services did you use? Strange for HN, but I am not being argumentative; I would just like to use similar tools myself. :-)
- crntaylor 13y ago
  Nothing fancy - the data is available on Robert Shiller's website[0] and I implemented the rule in Excel. [0] http://www.econ.yale.edu/~shiller/data.htm http://www.econ.yale.edu/~shiller/data.htm
socrates1998 13y ago
You are falling into the curve fitting trap that is epidemic in economics. This is typically what economic "scientists" do, they find a formula that fits a lot of past data, then they publish it as science. If they actually used it to make money, then it would be better, but that is almost never the case. People who make money in the financial markets don't publish their winning formulas. Why? For two reasons. 1) It probably isn't a hard rule or formula. It is probably a combination of factors that go into a decision that ultimately becomes a "gut feeling". Then, the best traders, usually get out if the trade doesn't work right away. This is because something unknown is acting on the trade, and since they have no idea what it is, they get out. 2) They want to use the formula to continue to make money, and since financial markets are very dynamic, they formula might not work if a bunch of people start using it.
- crntaylor 13y ago
  Believe me, I am more than aware of the perils of overfitting! The purpose of my comment isn't to say that using Shiller's P/E ratio is a good way to make money. In fact, I'm essentially saying the opposite - that while I think the research is good, it would be an inappropriate tool for most individual investors, because of the length of the required time horizon, and the length and magnitude of the drawdowns you'd have to endure. As an aside, I believe that your criticisms of economics are misplaced. Certainly there is plenty of poor research and curve-fitting that gets published in journals of economics. But there are also extremely capable economists whose understanding of data-mining bias and overfitting is far in advance of yours or mine, and who are extremely careful when evaluating models using historical data.
- Misterburns 13y ago
  Your statements about scientists are an overfit. Randomized controlled trials: http://m.newyorker.com/reporting/2010/05/17/100517fa_fact_parker http://m.newyorker.com/reporting/2010/05/17/100517fa_fact_pa...
- zmk_ 13y ago
  Insiders publish a sizable chunk of research. Not the currently winning formulas but something that stopped working or is too general a theory to be easily applied. E.g. for hedge funds this is one of the very few ways they can advertise to investors.
tanzam75 13y ago
> 5. Buy in 1973 and sell in 1992, realizing 2% annualized over 19 years. Again, you'd have to suffer losing over half your capital before you eventually came out on top. You seem to be ignoring dividends. The S&P 500 gave a total return of 11% nominal and 4.5% real from the high point in 1973 to the low point in 1992. (Note: I only have monthly figures for the 1970s.) SPXTR, Jan 31, 1973: 60.27 CPI-U, Jan 1973: 42.6 SPXTR, April 8, 1992: 457.16 CPI-U, April 1992: 139.5 Total nominal return: 457.16 / 60.27 = 7.59 Annual nominal return: 7.59 ^ (1/19) = 1.11 Total real return: 457.16 / 139.5 / 60.27 * 42.6 = 2.32 Annual real return = 2.32 ^ (1/19) = 1.045 Historically, dividends have accounted for over half the return, and thus you cannot simply ignore them. This is why I use the S&P 500 Total Return Index (SPXTR) to calculate returns, not the S&P 500 Index (SPX). Note: Taxes not included in the calculation. Alternative investments, such as bonds and money market funds, would've been taxed as well. You could've gotten tax-deferred compounding starting in 1975, when the Traditional IRA was created. Data sources: 1. GlobalFinancialData.com for SPXTR, extended backwards. Not freely available. 2. Bureau of Labor Statistics for CPI-U. Their servers remain up during the government shutdown -- but no data is being updated. ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt
- crntaylor 13y ago
  That's embarrassing - I thought that Shiller's "Real Price" had dividends already rolled into it!

onebaddude 13y ago

Thanks for this. I think a major flaw with the Shiller P/E is that there is no fundamental reason for choosing 10 years of earnings for the calculation. Why not 7, or 12? When events like 2008 happen, and earnings drop tremendously and temporarily, it puts a serious skew on the metric going forward (until that single year is no longer used in the calculation). It is, however, a useful tool for "guesstimating" whether future stock markets returns will be above or below historical averages.

_airh 13y ago

Where did you get this information from? What tools / services did you use? Strange for HN, but I am not being argumentative; I would just like to use similar tools myself. :-)

crntaylor 13y ago
Nothing fancy - the data is available on Robert Shiller's website[0] and I implemented the rule in Excel. [0] http://www.econ.yale.edu/~shiller/data.htm http://www.econ.yale.edu/~shiller/data.htm

socrates1998 13y ago

You are falling into the curve fitting trap that is epidemic in economics. This is typically what economic "scientists" do, they find a formula that fits a lot of past data, then they publish it as science. If they actually used it to make money, then it would be better, but that is almost never the case. People who make money in the financial markets don't publish their winning formulas. Why? For two reasons. 1) It probably isn't a hard rule or formula. It is probably a combination of factors that go into a decision that ultimately becomes a "gut feeling". Then, the best traders, usually get out if the trade doesn't work right away. This is because something unknown is acting on the trade, and since they have no idea what it is, they get out. 2) They want to use the formula to continue to make money, and since financial markets are very dynamic, they formula might not work if a bunch of people start using it.

crntaylor 13y ago
Believe me, I am more than aware of the perils of overfitting! The purpose of my comment isn't to say that using Shiller's P/E ratio is a good way to make money. In fact, I'm essentially saying the opposite - that while I think the research is good, it would be an inappropriate tool for most individual investors, because of the length of the required time horizon, and the length and magnitude of the drawdowns you'd have to endure. As an aside, I believe that your criticisms of economics are misplaced. Certainly there is plenty of poor research and curve-fitting that gets published in journals of economics. But there are also extremely capable economists whose understanding of data-mining bias and overfitting is far in advance of yours or mine, and who are extremely careful when evaluating models using historical data.
Misterburns 13y ago
Your statements about scientists are an overfit. Randomized controlled trials: http://m.newyorker.com/reporting/2010/05/17/100517fa_fact_parker http://m.newyorker.com/reporting/2010/05/17/100517fa_fact_pa...
zmk_ 13y ago
Insiders publish a sizable chunk of research. Not the currently winning formulas but something that stopped working or is too general a theory to be easily applied. E.g. for hedge funds this is one of the very few ways they can advertise to investors.

tanzam75 13y ago

> 5. Buy in 1973 and sell in 1992, realizing 2% annualized over 19 years. Again, you'd have to suffer losing over half your capital before you eventually came out on top. You seem to be ignoring dividends. The S&P 500 gave a total return of 11% nominal and 4.5% real from the high point in 1973 to the low point in 1992. (Note: I only have monthly figures for the 1970s.) SPXTR, Jan 31, 1973: 60.27 CPI-U, Jan 1973: 42.6 SPXTR, April 8, 1992: 457.16 CPI-U, April 1992: 139.5 Total nominal return: 457.16 / 60.27 = 7.59 Annual nominal return: 7.59 ^ (1/19) = 1.11 Total real return: 457.16 / 139.5 / 60.27 * 42.6 = 2.32 Annual real return = 2.32 ^ (1/19) = 1.045 Historically, dividends have accounted for over half the return, and thus you cannot simply ignore them. This is why I use the S&P 500 Total Return Index (SPXTR) to calculate returns, not the S&P 500 Index (SPX). Note: Taxes not included in the calculation. Alternative investments, such as bonds and money market funds, would've been taxed as well. You could've gotten tax-deferred compounding starting in 1975, when the Traditional IRA was created. Data sources: 1. GlobalFinancialData.com for SPXTR, extended backwards. Not freely available. 2. Bureau of Labor Statistics for CPI-U. Their servers remain up during the government shutdown -- but no data is being updated. ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

crntaylor 13y ago
That's embarrassing - I thought that Shiller's "Real Price" had dividends already rolled into it!