Tactical Asset Allocation with the Relative Total Return CAPE

Abstract

The extant literature documents an inverse long-term relationship between the cyclically adjusted price/earnings ratio (CAPE) and 10-year S&P 500 forward returns. This article shows that a different price/earnings ratio—the relative total return CAPE (RTRC)—has short-term signaling value. During 1901Q1–2019Q4, tactically shifting from the S&P 500 to 10-year Treasury notes yields a 79% increase in terminal wealth relative to buy-and-hold. Several RTRC filters yield positive and statistically significant alphas and superior Sharpe and Treynor measures. From a time-series perspective, the RTRC is indistinguishable from a level stationary series, whereas the CAPE appears to have a unit root.

TOPICS: Security analysis and valuation, fundamental equity analysis, portfolio construction, performance measurement

Key Findings

• ▪ The article demonstrates the feasibility of tactically switching from the S&P 500 index to 10-year Treasury notes using the RTRC.

• ▪ The historical simulation yields a 79% increase in terminal wealth relative to buy-and-hold during 1901Q1–2019Q4.

• ▪ Several filters yield positive and statistically significant alphas and superior Sharpe and Treynor measures.