No. of Recommendations: 1
Both the S&P 500 and your favorite, Berkshire Hathaway, are hitting record highs, so what are we arguing for? We should both be out celebrating.
It's a great quote, but unfortunately it is completely contradicted by the actual data results. ... So, other than being completely wrong, it's a great insight..
You're comparing apples and oranges. When looking for correlations, Citigroup's Director of Equities put market P/E ratios on the x-axis, whereas you put CAPE ratios there.
P/E and CAPE are not the same thing! The P/E ratio is simply price divided by trailing 12-months EPS. Whereas, to calculate CAPE, you need to average the EPS over the past 10 years AND you have to adjust those earnings for INFLATION. Inflation is a whole 'nother dimension that a simple P/E doesn't capture.
So you can't accuse Citigroup's Director of being wrong. He's a quant, just like you. When he says there's no correlation between simple P/E ratios and forward market returns, he's 100% correct. Because he's not talking about CAPE. If you plot simple TTM market P/Es against forward market returns, the scatterplot looks like a mess. No correlation.
If you put inflation-adjusted CAPE values on the x-axis, then, as your own study showed, there is still no ability to say anything about market returns over the next 1 to 3 years. But you start to see a correlation over the next 4 to 10 years. You see it using post-1996 10-year returns.
So here's the bottom line.
Can you use the market's simple P/E ratio to time the market over the next 1 to 3 years? No
Can you use the market's simple P/E ratio to plan your retirement which is 10 years away? No
Can you use the market's CAPE ratio to time the market over the next 1 to 3 years? No
Can you use the market's CAPE ratio to plan your retirement which is 10 years away? Yes, if you believe the post-1996 results will continue.
Is there a correlation between CAPE and forward 10-year returns since the early 20th century (120+ years)? No
