Shiller PE - Consistently good at predicting bear markets
by Bjørnar Mundal, on 06 April 2020 15:15
Shiller PE looks at the relationship between the price and earnings on the S&P 500. The indicator tracks the price earning ratio based on average inflation-adjusted earning from the previous 10 years, and is therefore also known as the Cyclically Adjusted PE Ratio (CAPE RATIO).
We have used Deep Alpha to test Shiller-PE's accuracy at predicting bear markets. The test has been performed on data going back to 1928, and it turns out that Shiller-PE has been consistently good at predicting bear markets.
In order to find the transformation with the highest predictive power, our technology automatically tests a range of different transformations of the underlying indicator on historical bear markets. The transformations we test are different values of moving averages, shift, rate of change, compare to average and inversion. The timeseries is split into training and validation in order to cope with overfitting.
We use the F1-score to assess the predictive power of the indicator, which looks at the harmonic mean between precision and recall of the transformation:
Recall = True Bear/(True Bear + False Bear)
Precision = True Bear/(True Bear + False Bull)
Essentially you want to see how good the indicator has been to predict True Bears and True Bulls. We provide a confusion matrix with information related to True Bear, True Bull, False Bear and False Bull.
Our analysis shows that the indicator is Bearish if todays Shiller PE is 0.5 point lower than the average value the previous year. In other words, a negative momentum in Shiller-PE is a bad sign.
Todays level of Shiller PE is 5.9 points lower than the average Shiller PE the previous 365 days. Therefore, todays Shiller PE indicates a bear market.
The analysis shows that the F1-score is 0.66, implying a high predictive power. As we can see from the confusion matrix, the indicator has above 80 % accuracy. (True Bear + True Bull). Additionally, the CACR figures shows the effect of using it as a signal:
It is also interesting to have a look the historical periods in which it has predicted bear. As you can see from the picture below it has consistently pulled you out of the market or reduced your risk during downturns.
We are continuously searching for new indicators that covers various aspects of the markets and the economy. When we discover indicators with high predictive power, we include them in our models. Therefore, Shiller PE was included in our Quantfolio US Model this week.