The Cyclically Adjusted Price-to-Earnings Ratio

The price-to-earnings ratio is one of the most widely used metrics when assessing stock valuation. The ratio highlights whether a company’s stock price is overvalued or undervalued and reveals its valuation compared to its respective industry group. P/E is calculated by dividing the market value price per share by the company’s earnings per share. A high ratio might indicate that a stock’s price is high relative to earnings and possibly overvalued. On the other hand, a low ratio could mean that the current stock price is low compared to earnings.

Although the ratio is relatively efficient when assessing stock valuation, prices and earnings are constantly changing. With that in mind, investors came up with the cyclically adjusted price-to-earnings ratio, CAPE. The CAPE ratio measures actual earnings per share over ten years to smooth out price changes in corporate profits over a business cycle.

Factor Investing

Ever since the Modern Portfolio Theory was created in 1952, asset allocation, risk management and diversification have formed the core governing principles when building a portfolio. However, more and more asset managers are shifting to strategies beyond MPT to increase returns and reduce the downside. These investment strategies include actively managed stock selection, tactical asset allocation, and the use of alternative investments. In these approaches, asset managers noticed that outperforming stocks shared specific traits that came to be known as factors. 

These factors include: 

• Size: The tendency for small-cap stocks to outperform large-cap stocks over time.
• Relative Price: The tendency for value stocks to outperform growth stocks over time.
• Quality: Companies with higher profitability ratios often outperform those with lower profitability ratios over time.
• Momentum: The propensity for stocks with positive momentum to outperform the market in the near term and those with negative momentum to underperform the market in the near term.
• Volatility: The tendency for a security’s value to remain stable, changing in value at a steady pace over time
• Dividend Yield: The tendency for companies who pay steadily growing dividends to outperform the market over time. 

Catching a Falling Knife

In investing, the meaning of ‘catching a falling knife’ might seem obvious, yet the implications are not. The term suggests that buying into a market with a lot of downward momentum can be extremely dangerous, only comparable to catching an actual falling knife. However, if timed perfectly, a trader that buys at the bottom or near the bottom of a downtrend stands to gain significant profits if the price recovers. That said, there is a risk that the timing will be off, and there could be significant losses before any gains. All in all, most advisors preach against buying a stock that keeps dropping in value, that is, if you don’t want to be part of a story such as that of Enron or Lehman Bros.