If you’re seething over the performance of your broad index funds, here’s a new investment approach that might appeal: The Shiller Barclays CAPE U.S. Index Family – a set of newly announced indexes that attempt to hone in on undervalued sectors in an attempt to drive better returns.
The Shiller here refers to Robert Shiller, the Yale economist and author of Irrational Exuberance, among other titles. He has become famous as a bubble spotter, having warned about the craziness of the 1990s dot-com era and the U.S. housing insanity last decade.
But Mr. Shiller is also famous for constructing a variant of the popular price-to-earnings ratio. Instead of using trailing 12-month earnings or expected earnings as a valuation measure for stock market indexes, Mr. Shiller has been using a 10-year rolling average. That gets around business cycles and provides a smoothed-out earnings profile – and provides a better indication of whether stocks truly are undervalued or overvalued.
The new indexes look for cheap sectors based on this approach, finding those with low cyclically adjusted price-to-earnings, or CAPE. The numbers are persuasive. Using data going back to 1902, Mr. Shiller found that an investing strategy that focused on sectors with low cyclically adjusted price-to-earnings ratios outperformed by an average of 1.13 per cent a year. It adds up.
The lower the CAPE, the better the future performance. The higher the CAPE, the worse the performance – although the strategy gets a little more complicated than that because it compares the current ratio with the ratio in previous years to get a relative measure.
According to Mr. Shiller’s current sector breakdown for the S&P 500 in August, financials are the cheapest sector, with a CAPE of just 12. Energy stocks are also cheap, at 16. And industrials look pretty good, too, with 19.8.
But consumer discretionary stocks are pricey, with a CAPE of 43.4. And telecom stocks are also expensive, at 34.9. “That doesn’t look good,” Mr. Shiller said. “It’s predicting essentially no return, so we don’t like that.”
The three new indexes incorporate this information – identifying the five cheapest sectors, then looking at momentum factors and reducing the short list to four sectors. One index tracks these four sectors. Another tracks all sectors, but underweights or overweights them based on their attractiveness. And the third one adds a little short-selling into the mix – not to goose returns but add stability.
“The Efficient Markets Hypothesis has reigned for many years – the idea that markets are essentially perfect,” Mr. Shiller said. “I think we’re starting to lose faith in that.”
The new indexes attempt to discover value in a better way, he added.
“There are so many strategies that work for a while and then stop,” Mr. Shiller said. “I think we have something that has been pretty stable and will probably continue to work. There are no guarantees, but it is something that I would recommend. Given the fluctuations in valuations that occur, you want to stay in the low-valued sectors.”
Unfortunately, the indexes are designed for big players right now – the pension funds, endowments and the like. But as they told me on a conference call on Wednesday, they are examining all options. So you never know: There could be an exchange trade fund coming soon.