John Hussman, manager of Hussman Strategy Growth Fund (HSGFX) proposed price to peak 10 year average earnings as a long term stock market valuation metric. Compared with the normal one year price to earning ratio, Price to Peak Earnings would eliminate short term noise. This is similar to Shiller's ‘Cyclically Adjusted Price Earning' ratio (CAPE10) and Warren Buffett's stock market GNP/GDP metric. In his weekly commentary on Dec 5, 2005, titled as 'Earnings Revert to the Mean, Stocks Will Struggle', he proposed a simplistic method: "buy when Price to Peak Earnings is lower than 15 and sell when it exceeds 19.5". John Hussman has been using this as the valuation yardstick to manage the Hussman Strategic Growth Fund HSGFX.
It is interesting to examine how effective using such a metric as a long term stock market timing indicator. Similar to the Warren Buffett's stock market GNP/GDP metric and Shiller's CAPE, the following strategy characterizes the stock market valuation into the following five categories based on the ratio of the current Peak PEs to the long term average Peak PEs:
- Significantly Overvalued (SO): such as if the ratio >= 150%
- Modestly Overvalued (MO): such as if 117% <= ratio < 150%
- Fairly Valued (FV): such as if 83% <= ratio < 117%
- Modestly Undervalued (MU): such as if 67% <= ratio < 83%
- Significantly Undervalued (SU): such as if ratio < 67%
These five categories are determined by four valuation parameters (such as 150%, 117%, 83% and 67% in the above). At each rebalancing (adjusting) period (such as weekly or monthly), the strategy decides at what region the US stock market valuation is and then does the following rebalancing:
- SO: 0% in stock, 100% in cash.
- MO: 25% in stock, 75% in cash.
- FV: 50% in stock, 50% in cash
- MU: 75% in stock, 25% in cash
- SU: 100% in stock, 0% in cash
The stock market exposure is through buying Wilshire 5000 total return index (^DWC) or it could be set by users. Users could adjust the valuation parameters to get an effect like only buying at significantly undervalued (SU) level and selling at significantly overvalued (SO) level. Some of model portfolios of this strategy are:
- SO: >=150%, MO: [117%, 150%), FV: [83%, 117%), MU: [67%, 83%), SU: <67%
- SO: >=150%, MO, FV, MU: [67%, 150%), SU: <67%
A model portfolio called P Hussman Peak PE Market Timing Strategy Buy 19.5 Sell 15 Weekly is also maintained to live monitor the strategy suggested in 'Earnings Revert to the Mean, Stocks Will Struggle'.
The following table compares the performance of the three long term stock market indicators. All of the portfolios are based on ‘buy at significantly undervalued and sell at significantly overvalued' strategy.
All of the strategies have achieved better returns and much higher Sharpe ratios compared with Wilshire 5000 total return index.
On Friday 11/13/2009, Both Buffett and Hussman metrics indicated the market was fairly valued: Buffet Total Stock Market Valuation to GNP ratio was 78.6% while Hussman's Peak PE10 to the long term Peak PE10 average was 1.04 (current peak PE 10 was 12.4 and the long term average was 11.9). Shiller CAPE10 to its long term average indicates the market was 22% overvalued. It should be noted that John Hussman has been very cautious recently, pointing out the uniqueness of the current economic situation. Interested readers should read his latest weekly commentary here.