Tuesday, August 16, 2016

CAPE and mean reversion

In early days of Robert Shiller's career, he made a discovery that would eventually win him a Nobel Prize. He found that stock prices bounced around too wildly to be explained by standard theories. This has been labeled the “excess volatility puzzle,” and financial economists have written countless papers trying to explain it. But now, excess volatility provides a clue to a possible problem with some of the forecasts we’re seeing in the presidential race.

Excess volatility means that a forecast is more volatile than the thing it’s predicting.

That’s why Shiller’s excess volatility puzzle showed that the stock market probably isn’t efficient. If stock prices have excess volatility, then unusually high prices today imply that stocks are too expensive and are more likely to fall than rise. In fact, that’s exactly the principle that drives Shiller’s cyclically adjusted price-to-earnings ratio, or CAPE -- a popular measure of how expensive or cheap stocks are. Because stocks are more volatile than prices, CAPE generally tends to revert to the mean. This won’t tell you exactly what stocks will do tomorrow or next week, but they offer the promise of a little bit of predictability in an otherwise ineffable market.