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WHEN IT COMES to financial decisions, many investors subscribe to an approach known as evidence-based investing. The idea, as the name suggests, is to base decisions, whenever possible, on data rather than on intuition or other informal methods.
This sounds logical. It isn’t perfect, though. Economic and financial indicators have weaknesses which are important to be aware of.
Consider, for example, the Cyclically-Adjusted Price-to-Earnings, or CAPE, ratio, developed by Robert Shiller, a Yale professor and Nobel laureate, along with a colleague. Owing to its pedigree, the CAPE is highly respected. And a study by the Vanguard Group found that the CAPE had the strongest ability to predict market returns among fifteen different metrics it tested. For these reasons, many view it as the gold standard for stock market valuation. But how accurate has it been?
For years, the CAPE ratio has been flashing red. Since 2018, in fact, it’s been more elevated than it was at the peak in 1929, just before the crash. It seems to be indicating extreme risk. And yet, the market has continued to move higher with only temporary setbacks, defying the CAPE’s warnings.
Even Shiller himself has acknowledged that the CAPE’s predictive abilities can fall short. In 2021, he made this seemingly contradictory statement in an opinion piece: “The stock market is already quite expensive,” he wrote, “But it is also true that stock prices are fairly reasonable right now.”
Here’s how he explained this seeming contradiction: While the stock market at the time was expensive by historical standards, he noted that investors should never look at any one metric in a vacuum. Investments need to be considered in comparison to other available options. On that basis, he said, stocks were not expensive, because bonds at the time were also expensive.
Recognizing how the CAPE can register misleading readings under certain conditions, Shiller and a colleague have since developed a modified version of the CAPE called the Excess CAPE Yield. This new metric helps investors compare the prospective relative returns of stocks and bonds. Shiller’s message, in other words: The original CAPE ratio on its own shouldn’t be seen as conclusive.
Another well-respected metric that’s stumbled in recent years is the Sahm rule. In general terms, this rule says that when the unemployment rate begins to increase at a particular rate, a recession is likely. In back-testing, it’s been shown to be remarkably accurate. Since 1959, it would have generated just two false positives.
A few years ago, however, the Sahm rule threshold was breached, theoretically indicating a recession. But Claudia Sahm, the rule’s creator, was quick to explain why investors shouldn’t be nervous. “The Sahm rule is likely overstating the labor market’s weakening due to unusual shifts in labor supply caused by the pandemic and immigration,” she wrote. And in the years since, as Sahm guessed, the economy and the stock market have indeed avoided recession.
The upshot: Economic indicators may work—and even work reliably—for a period of time, but then break down when something about the economy changes in a fundamental or unique way, as occurred in the wake of Covid.
Economic indicators carry another fundamental flaw: In some cases, an indicator might be correct in its prediction but less than accurate in its timing. It might tell us what’s likely to happen, in other words, but won’t tell us when that event is expected to occur. Probably the most famous occurrence along these lines was in 1996, when Alan Greenspan, then the chair of the Federal Reserve, proclaimed that the stock market was exhibiting “irrational exuberance.”
Greenspan turned out to be absolutely right: A bubble was forming in the market, valuations were irrational and a crash was coming. But he didn’t get the timing right. The crash that ultimately occurred didn’t arrive until early 2000—more than three years after he issued his warning. And in those intervening three years, the market more than doubled. Investors who got more cautious in response to the initial warning would have missed out on significant gains.
Along the same lines, consider what occurred with the pandemic. When Covid appeared in 2020, it seemed to arrive completely out of left field with no warning. The reality, though, is that certain experts did have pandemic risk on their radar. A 2019 risk assessment by the Federal Emergency Management Agency (FEMA) highlighted the risk of a pandemic among a short list of concerns. The problem, though, was that the report was vague, describing a risk but without any indication when it might occur. It was like a clock with no hands.
It was because of examples like this that the fund manager Peter Lynch has said, “It’s futile to predict the economy, interest rates, and the stock market…If you spend 13 minutes a year on economics, you’ve wasted 10 minutes.”
That’s humorous, but where does that leave us? On the one hand, we know better than to consult storefront psychics. But economic indicators aren’t terribly reliable either. Investor Howard Marks offers a helpful answer. In his book Mastering the Market Cycle, Marks offers this suggestion: Imagine, he says, a jar filled with a mix of balls of various different colors. No one can tell with the naked eye how many there are of each. But if you can at least have a sense of the mix, that can be helpful. By the same token, no economic indicator should be seen as conclusive, but taken together, they may provide a sense of where things stand.
What does this mean in practical terms? Suppose, for example, you’re considering rebalancing your portfolio and wondering how aggressive to be in reducing risk. You could use Marks’s guideline in this case. If the market seems high, you might be a little quicker to reduce risk. But at the same time, we should always keep in mind the “irrational exuberance” episode as a cautionary tale. It’s a reminder to never veer too far in any one direction. As I’ve suggested before, a center-lane approach often represents the best path forward.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
Larry Swedroe wrote a post on Substack about CAPE ratio that is worth a read: https://open.substack.com/pub/larryswedroe/p/the-cape-that-cried-wolf-has-the?r=9qivf&utm_medium=ios
Adam’s final sentence says absolutely all I need to know. The center lane is my lane and that’s where I intend to stay. I know enough to know that there’s a whole lot that I don’t. If active managers don’t know what to make of the indicators, what chance do I have?
Evidence shows that structural market declines / periods of tail risk have been accompanied by/in proximity to Treasury “yield spread inversions”.
Since 1950, periods of stock market risk have been identified by the alignment of 4 empirically defined variables :
a) the S&P 500 price residing below its 10 period moving average (monthly basis) value on “June 30th”or “July 31”
b) the YTD S&P500 return being negative into June 30th / July 31
c) variables a & b falling within “Presidential term years” 1, 3, or 4 **
d) the 3 month T bill yield being higher than the 10 year Treasury note yield (yield spread inversion) within 24 month proximity to variables a, b, & c
** 2nd or Mid term years are exempt from the process as their July – June returns ( and even forward 24 month returns ) have been predominately positive
Signaling record :
period. S&P500 bonds
7/1969 – 6/1970 -22.8% -3.7%
7/1973 – 6/1974 -14.5% +1.2%
8/1981 – 7/1982 -13.2% +20.1%
7/2001 – 6/2002 -18.0% +5.6%
7/2008 – 6/2009 -26.2% +6.9%
FRED interest rate data even indicates a yield spread inversion as late as Feb 1930 – with the other variables aligned in July 1931 – leading to a 12 month loss of -66% and bond return of +3.8%
Many of those periods have certainly been accompanied by “excessive valuation readings”, yet in light of the high odds of a positive market return in the next 12 – 24 months ( 2026 being a 2nd or Mid Term year ) and a Treasury yield spread that has been ‘normal” since Dec 2024, it’s doubtful that a structural market decline is in the cards anytime soon.
I have looked at valuation, economic and other indicators for years and none could predict what stocks would do in the next 1-3-6 months and even years.
This is why I don’t follow them.
But, I found what a “simple” way that works and have used it successfully for years.
My goal was to find something that triggers a trade about twice annually. If it’s wrong, I know it within a week and I buy back immediately. If I’m right, I’m out for several weeks. In 2022 I was out for 10 months.
The only way to get better is to pay attention to the right things, practice and get better.
You can’t learn to swim well reading a book, you actually must swim.
In order to understand stock prices, you have to look at the modern economy.
In the 1980s, say, things were entirely different. The demographics, the distribution of income and wealth, the tax system. Stock prices made sense for the structure of the economy. The production of physical goods was important, and commodities were a large part of the economy. Most people relied on earned income to buy these physical goods. The money supply was controlled to prevent the price of physical goods from rising.
Today, everything is entirely different. People earning money to buy physical goods is a backwater of the economy; this is something poor people do. The stock-buying class lives in a world of virtual reality and artificial intelligence. Their money and assets are synthetic too. There are trillions of dollars in M1 and M2 that are not needed for the physical economy. In this artificial reality, anything is possible.
What is interesting is that you can still cash in your virtual wealth and buy stuff at the store.
Apparently “they” were right years ago when we heard that rules were meant to be broken.
I enjoy all your articles, Adam. Thanks and please keep contributing. I have learned that the INDEX is the answer. After about 20 years, I found my average of all the ups and downs of buying individual stocks, I was right at the S&P500 amount, and very happy it was not less. I am with Buffett, on that index and have 85% of my portfolio in stocks at Vanguard, VOO.
It’s going to be very interesting to see how AI changes our ideas about data driven prediction. No doubt it will find trends people have overlooked.
This week at my job a colleague asked me for help with an image analysis problem. After trying a few traditional approaches with minimal success with one metric of feature differences, I uploaded eight images to our firewall protected AI and prompted it to define morphological measurements which would be relevant and on each to rank the images. In about 20 seconds it had ten different features measured and ranked the images with explanations for each too. It correctly grouped the images from their sources, which we knew. Very impressive.
But will it be any more accurate at predicting? Financial markets, or in the case of the images of biology at work, may change suddenly based on events extrinsic to existing data.
Interesting comment! History has shown that most (if not all) efficient market “anomalies” (e.g., factor investing) are soon arbitraged away and stop working once everyone finds out about them. AI says this is called “alpha decay” (“factor decay” in factor investing). Efficient markets quickly adapt to new information – I suspect it will be no different with AI-discovered anomalies. AI should make markets even more efficient – more reason to index!
Or, as noted financial journalist Jonathan Clements would say, don’t attempt to time the market.
Thank you for another insightful and practical article!
My asset allocation is 50% stocks, 20% international, in broad index funds. I rebalance when I take my RMD, or if I happen to notice I’m off by more than 5%. Everything else is noise.
Great article Adam. Robert Shiller is one of the best out there. He’s one of the few academics/Nobel winners that will call out weaknesses in the efficient market hypothesis. I wonder if the passive bid plays a large part in the stock market’s inexorable rise to such high valuation levels as more and more money is fed into the highest cap stocks regardless of value.