The Analysis of Stock Returns in The London Stock Exchange in the Context of the Cyclical Adjusted Price to Earnings Ratio Signals

Abstract

This thesis aimed to analyse the signalling capability of the Cyclically Adjusted Price to Earnings (CAPE) ratio and to analyse the performance of asset pricing models in the context of different market sentiments, as highlighted by the CAPE ratio. The behaviour of stock returns in the light of different asset pricing models is evaluated and compared in different subsamples classified as under priced, fairly priced and overpriced markets. The two main models used in this analysis are the Capital Asset Pricing Model (CAPM) and the Fama and French (1993) three factors model. This framework was also used to evaluate the Efficient Market Hypothesis that postulates that markets are efficient all the time. To achieve the study’s aim, the CAPE ratio was applied to the FTSE100 stock market index for the period from December 1998 to December 2017. The CAPE ratio identified the periods where the market was overpriced, fairly priced and under priced. Next, an active investment strategy based on the CAPE ratio signals was tested on the full sample and compared to a passive investment strategy to examine the effectiveness of using the CAPE ratio as a signalling tool for different trading strategies. The next step was to identify the different phases of the market that can be classified as overpriced, fairly priced and under priced markets, as per the signals of the CAPE ratio. The asset pricing models were employed on stock portfolios and their performance was examined in each one of the three market phases and on the full dataset. The results of this study showed that the trading strategies based on the signals from the CAPE ratio are not likely to produce abnormal returns when compared to a buy and hold trading strategy in the long run. The CAPM test results showed that the subsequent returns were not fully in line with the predictions of the model in longer time periods as compared to shorter time periods, especially when the market was classified as fairly priced by the CAPE ratio. However, the pattern of the portfolios returns in different subsamples was not consistent. Thus, the CAPE ratio does not appear to be a suitable signalling tool in explaining the stocks returns behaviour in the light of the CAPM. The analysis of the Fama and French three factors model tests show that the model was suitable in explaining returns in most cases in the three subsamples and the full sample. The CAPE ratio seemed to have provided a good signal about subsequent returns if stock returns are analysed in the light of multi-factors like the size factor and value factor. However, it was not possible to beat the market based on the CAPE ratio signals. The performance of stock returns was not consistent as predicted by the CAPE ratio hence it was hard to classify any particular trading strategy based on the CAPE ratio’s valuation signals. Thus, the Efficient Market Hypothesis stands strong in its conclusion that the markets are efficient and there are no easy arbitrage opportunities that investors can consistently exploit by employing certain ratios like the CAPE ratio to get signals about the future direction of the market.