No. of Recommendations: 3
Tedthedog,
I really enjoyed Part I of your analysis and I really enjoyed following as you dug into this. I don't quite understand what you hoped to conclude though from your analysis in part II.
I didn't see any of the experiments you did as an invalidation of CAPE. In the FAPE I experiments, if I understood it correctly, you took the straight line best fit to the 10 year smoothed earnings used in CAPE. That straight line looks pretty close to the smoothed earnings, since smoothing earnings takes out a lot of the volatility to begin with. So no surprise, it works pretty well and behaves similarly to what CAPE would do in terms of correlating to future returns. I wasn't sure what kind of explosion that implied about CAPE. Its what you would expect, no? Certainly doesn't seem contrary to what CAPE theory suggests. It maybe even supports it - e.g., using smoothed earnings help with longer term expected return?
For the FAPE 2 experiment, you used smoothed market prices as the denominator. Random in the short term but less random over time. Aggregate prices over time at least have some correlations to aggregate earnings, even if that doesn't work for individual stocks. So the stock prices over time, if smoothed, should also be correlated to CAPE earnings, but probably less so and with a different multiple. If I understand your analysis correctly, that is also what you found.
I get that multiple things that have smoothed linear trajectory that goes up over time could seem like they have the predictive power of CAPE ... as long as they look similar to CAPE. But how does that blow up CAPE, which has a theoretical grounding for the why?
