Es-cape-ing from Overvalued Sectors: Sector
Selection Based on the Cyclically Adjusted
Price-Earnings (CAPE) Ratio

Abstract

This article explores the effectiveness of the cyclically adjusted price-earnings (CAPE) ratio to detect over- or undervaluation of sectors within the U.S. economy. The authors modify the original notion of the ratio from several empirical studies by John Campbell and Robert Shiller, not only to ensure uniform corporate payout policies, but also to allow comparisons across the sectors’ potentially differing accounting standards and varying growth expectations. Considering sector-level CAPE information back to the early 1980s, the authors translate the CAPE-based valuation signals into a sector rotation strategy, whose long-term value nature is complemented by a supplemental momentum adjustment, in order to eliminate value traps. The performance enhancement associated with the CAPE-based sector rotation extends to European sectors as an out-of-sample test.

TOPICS: Accounting and ratio analysis, in markets, portfolio construction