Is CAPE of above 23 extraordinary for a bullish stock market?

In his article "Has the Nearly 2-Yr-Old Bull Market Topped Out?" the respected by me Mark Hulbert speaks about his concerns that the current bull market might be surpassing its sound valuation levels and it might be near its end.

The author uses a CAPE measure to prove his point. CAPE is a modified P/E ratio which was made popular by Robert Shiller, a Yale University professor who uses it in his book "Irrational Exuberance". CAPE stands for "Cyclically Adjusted Price Earnings" and it differs from the general P/E in that its denominator (the E) is average inflation-adjusted earnings over the trailing 10 years. The data the article cites could be found on the Mr. Shiller's website. It's a very complete data set in the Excel file format.

According to Mr. Hulbert's calculations the current CAPE of 23.7 (as of the date of his article) is considerably higher than the average CAPE of 18 for the bull markets of the last century which he examines. The conclusion is that it would be hard to argue that the market is undervalued or even fairly valued.

Now my remarks.

• What Mr. Hulbert is missing is that as a rule of thumb a bull market could surpass a lot its sound valuation levels especially in its extreme points before it tops out and converts to a bear market. And such a conversion doesn't happen overnight. We know a bull market will stop but we usually don't know exactly what time will pass ebfore it really happens. Exiting too early could save your money but also would mean a lot of unrealized profits. Usually choosing one over the other is a matter of personal preferences and attitude.
  
  
• Now as we stand on the understanding that a higher CAPE is a normal phenomenon for a bullish market, it would be nice if the article of Mr. Hulbert shows at what ratio the average CAPE the author calculated was overrun by the real CAPE for the years of the bull markets it discusses. But it doesn't. It just states the current CAPE is higher than the avegare one.
  
  If we dig the data from Mr. Shiller's file we see that the current month CAPE is 23.69 and it's indeed higher than the average 18 Mr. Hulbert calculated. But during 2007 there was noticed a CAPE of above 27 (50% above the average value of 18), during 2004 - above 26-27 (again about 50%), during 1999-2001 - above 40 (122%)! In all the period between the late 1995 to 1999 CAPE values were above 24 with an average value of about 31.5 (75%).
  
  So the current CAPE is 30% above the average of 18 but we've seen even higher differences during the past 15 years. Seen in that light a 23 CAPE doesn't seem so extraordinary.
  

If you are a strictly value oriented investor I understand that leaving your money in a market that you believe is overvalued is hard and against your logic. Not everyone in the market is such a type of investor though. That makes the market move and the imperfections present opportunities.

EURUSD possible trade on the sale side

During the day the EURUSD pair has generally been up for the Euro with its value going twice to 1.3665. Still it was unable to break or even reach the barrier at 1.3680. But the more upward it goes the more favorable the risk/reward ratio seems measured toward that level. The longer time-frame graphs suggest there could be an upward movement of the US Dollar soon of roughly 100 pips or even more.

If entered on the sell side at the current level of 1.3645 with a stop at 1.3685 and a first target 1.3600, the risk/reward is slightly above 1 which is not very profitable. However the higher the pair goes toward 1.3670/80 area, the more profitable and less risky the R/R ratio gets.

VAR, Risk / Reward ratio and money management

A positive risk/reward ratio is the heart of a successful trading.

Some thoughts derived from the yesterday possible trades.

The trades:

1. sell @ 1.3830, risk/reward (r/r) = 0.42 (losing 30 pips, gaining 70pips), closed @ 1.3780, 50 pips gain
2. sell @ 1.3805, r/r ratio = 0.28 (risking 10 pips, gaining 35), stopped out @ 1.3815, 10 pips loss

Total: 40 pips gain

Put that way the above figures mean almost nothing because they don't translate into real money. How they will translate depends greatly on the invested amount and its portion of your whole portfolio. So if you decide to put 5% of your portfolio in a deal and risk it, basically that's your Value at Risk (VAR). In general the greater the VAR, the faster the movement of your account (growing or vanishing). If you decide to have a VAR of 50% in a simple move you might double the account or zero it.

Let's say you are willing to risk 5% of your capital (your whole portfolio). The VAR is 5%. Simply this means that you might have 20 wrong trades in a row before you zero out your account. So if you want to have a greater number of tries, lower the risked amount. 1% VAR = 100 wrong trades in a row.

Where is the risk/reward ratio here? The risk/reward rule basically says that the amount of profit you expect from a deal should be greater than the amount you are willing to risk! As we deal with future events that ratio happens to be an imaginary variable strongly dependent on our own ability to successfully expect the correct future events! Thus the risk/reward ratio is often used to distinguish between possible bad and good deals.

Both the value of VAR and the risk/reward ratio have a direct impact on the level of stops you choose. Let's look again at the examples above. In the first trade the possible loss in pips was set to 30 by the stop being 30 pips away from the entry level. If the account was of $1000 and the player was willing to risk 5% of it that would translate to a possible loss of $50. $50 loss for 30 pips is achievable by trading almost $16500 which means the player had to open a position of $16500. The important point is that the player has chosen that deal because he or she is expecting the gain from the trade to be bigger than the possible loss.

The level of the stop could vary depending on the expectations of the player but if the value of VAR stays the same all other variables could be changed accordingly bearing the same risk (measured by the amount of possible loss) to the portfolio. It doesn't matter if you trade a position of $33000 and put a 15 pips stop-loss or a position of $16500 and 30 pips stop-loss. The VAR in both cases is $50. What changes is the probability of successfully striking your stop with the relation being that closer stops get hit more often. That probability could shorten the life-span of your account which means that in general the wider the stop, the better.

Combining winning and losing deals which have had a positive risk/reward ratio the player might successfully manage the growth of his or her account.

EURUSD on the hour

The EURUSD pair ended the hour at 1.3778 - 50 pips below the possible entry level at 1.3830. Still there is some room for a fast drop to 1.3750 or even to 1.3730/20 (50% of the Fibo retracement). Depending on the client risk attitude the short USD trade could be closed now. Another strategy is to put a stop at 1.3780 in order to preserve the profits till now.

EURUSD Short-term possible trade

The upward movement of the Euro shows some signs of exhaustion and a possible retreat to 1.3750/60 could be formed. The European currency failed twice for the last hour to break above the 1.3845 level and there is a bearish hidden divergence formed on both the 15m i 30m graphs. An entry at the moment (at 1.3830) has a positive risk/reward ratio of 0.42 which translates to a twice bigger gains than the possible losses. An even more favorable entry could be formed at the 1.3845 level if the pair gets there again before dropping down.

EURUSD Short-term Technical Analysis

The technical EURUSD (Euro / USD) picture for the day and current situation (15min graph) is as follows:

• main direction (daily) - Up (Euro rises as US Dollar falls)
• current situation - on the edge, possible reversal in the way following a last upward movement.

 The 15 min graph shows the EURUSD pair is in the middle of its upward movement. The danger presented by the negative MACD values could be temporarily offset by the oversold condition (shown by the lower values of Stochastic at the moment). This could lead the pair to new highs above the previous high at 1.3836. The negative MACD however could signal the end of such upward movement and a fail to probe strongly that level would prove such possibility. At that point the Stochastic might well be in overbought condition and further ease the going down.

The great danger to any continuation of the upward movement of the Euro are the negative MACD divergences seen on the 1h and 4h graphs. Still there is a space to go up and any down movement could be followed by a strong reversal.

Having in mind the above conditions a fall to at least 1.3790 is to be expected soon. Having that level broken, 1.3770 is the next target.