You Could Have Missed... | #184

Episode Summary

Executive Summary: Meb Faber argues that CAPE-based valuation timing is misunderstood: while avoiding expensive U.S. stocks in 1993 would have missed huge gains, valuation still works when used to compare opportunities across assets and global markets. He shows that expensive markets tend to have worse future risk/reward, and that rotating into cheaper assets or countries can improve returns and reduce drawdowns.

Main Topics: Why CAPE is criticized as a timing tool (Priority: 5/5): The episode addresses the common claim that CAPE 'doesn't work' because investors who sold after high valuations missed large gains. Faber frames this as a misuse of valuation expectations rather than a failure of the metric. 1993 U.S. market valuation and missed gains (Priority: 5/5): Using 1993 as the case study, Faber explains that CAPE had just moved above 20, prompting a hypothetical conservative investor to exit stocks and miss a strong multi-decade rally. Valuation as a probabilistic rather than binary signal (Priority: 5/5): Faber argues CAPE is a blunt tool that shifts odds in an investor's favor; it does not predict exact market turns or guarantee losses in expensive markets. Asset allocation alternatives after exiting stocks (Priority: 4/5): He compares returns of U.S. stocks versus government bonds to show that even if one exited stocks, alternative assets could have produced respectable, smoother returns. Switching between stocks and bonds using CAPE (Priority: 5/5): Faber tests a simple rule: own stocks when CAPE < 20, bonds otherwise. He says this improved risk-adjusted returns and, with 30-year bonds, even matched or exceeded stock returns with lower drawdowns. Global value rotation using CAPE (Priority: 5/5): He broadens the framework beyond U.S. assets, arguing that CAPE is most useful when applied globally to find the cheapest stock markets rather than to time a single market in isolation. Blackjack analogy for investing discipline (Priority: 3/5): The blackjack example is used to illustrate that a winning short-term outcome does not make a decision statistically sound, reinforcing the difference between outcome and expected value.

Key Arguments: A high CAPE does not mean markets must fall; it means future returns are likely to be lower and drawdowns more likely, so valuation is about probabilities, not certainty. The 'CAPE doesn't work' critique is flawed because it assumes valuation should provide a perfect in-or-out signal for one market, which is an unrealistic standard. If an investor sells an expensive market, the relevant question becomes where the capital is redeployed; comparing only to cash is incomplete. Rotating into bonds or cheaper global equity markets can improve risk-adjusted returns even if it means missing some upside in the original market. The best use of CAPE is cross-sectional: identifying the cheapest markets or asset classes globally, not just timing one market in a vacuum. Historical data show expensive starting valuations generally lead to weaker 3- to 10-year outcomes, though some expensive markets still produce strong returns. Investors often overestimate their ability to endure drawdowns, so valuation signals can help avoid behaviorally difficult positions.

Data Points: Missed gains from selling U.S. stocks in 1993: 961% - Estimated gains foregone by exiting expensive U.S. equities after CAPE crossed above 20 and holding out of stocks through 2018. CAPE level in late 1992: Just above 20 - The market valuation level that prompted the debate; high versus historical average but not extreme bubble territory. Historical average CAPE: Around 16 - Used as a reference for evaluating how elevated the market was in 1993. Roaring 20s CAPE peak: 33 - Cited as an example of a far more extreme valuation than the 1993 level. Average annual U.S. stock return (1993-2018): About 9% - Benchmark return used to show why critics claim CAPE failed if judged by missed upside. Average annual government bond return (1993-2018): About 6% - Alternative deployment of capital after exiting stocks. Average annual 30-year Treasury return (1993-2018): About 8% - Presented as a smoother-return alternative to stocks with lower drawdowns. Sharpe ratio: U.S. stocks: 0.47 - Risk-adjusted return measure for the 1993-2018 period. Sharpe ratio: 30-year bonds: 0.39 - Lower than stocks but still close, indicating comparable risk-adjusted performance. 10-year bond return under switching system: About 7% (up from 5.6%) - Result when using CAPE < 20 to be in stocks and otherwise hold 10-year bonds. 30-year bond return under switching system: 9.28% - Switching system result that slightly exceeded the stock market's 9.1% annual return. U.S. stock return in switching comparison: 9.1% - Baseline return used to compare the CAPE-based switching strategy. Cheapest global stock markets return: 14% - CAPE-based global value strategy return, said to outperform U.S. stocks by about 4 percentage points annually. Average CAPE of cheapest global markets: Around 11 - Used to contrast cheap versus expensive global equity markets. Average CAPE of expensive global markets: Mid-20s - Used as a comparison point for expensive markets in the global strategy discussion. Dividend yield: cheap global markets: Over 4% - Presented as another way to frame the cheap-versus-expensive market distinction. Dividend yield: expensive global markets: Below 2% - Used to illustrate the valuation gap between cheapest and most expensive markets. CAPE-based value strategy cumulative gains: 3,051% - Estimated gains if the investor had moved from expensive U.S. stocks into the cheapest global markets.

Pivotal Quotes: "You would have missed 961% in gains and using the CAPE ratio, and that's a good thing." — Meb Faber: Episode title and central thesis introducing the valuation-timing case study. "Valuation is a blunt tool that may help tilt the probabilities in your favor, but it does not guarantee a certain desired outcome." — Meb Faber: Core explanation of how CAPE should be used. "The real value of CAPE, or any valuation metric, is when it's applied to a global investment set, telling you which assets or markets are likely to treat your money the best." — Meb Faber: Conclusion arguing for global asset allocation rather than single-market timing.

Implications: Listeners should treat CAPE as a probabilistic allocation tool, not a market-crystal ball. Its strongest use is comparing opportunities across markets globally, where valuation can improve returns and reduce drawdowns over time.