When to Buy and When to Sell Equities?
Published: September 2012
This paper reviews three investment models with a basis in economics which try to answer questions about the relative value of equity markets. Three basic approaches are critically analysed from the perspective of their broad conceptual underpinnings, the available evidence and their data requirements. These three are Professor Shiller’s Cyclically Adjusted Price- Earnings Model (CAPE), Tobin’s q (QR) and the Equitisation Ratio (ER). The paper finds that although there still remains disagreement about the signals on relative market valuation given by the different valuation models, an analysis of the period 1952 to 2010 of their performance in relation to the S&P 500 index in the United States shows that the three measures move together very closely and, apart from a limited number of periods, all of them provide the same signal of an over- or undervalued index. However, all of the models have signalled periods of significant length when the stock market is relatively overvalued or undervalued, without any corrections in the value of the S&P 500. The length of these periods, despite the fundamental warnings given by these methods, can make a considerable difference to the return on any fund focused on short-run performance. This limits their use to investors more interested in the long-term.