Relative CAPE Sector Rotation
Buy historically cheap sectors while momentum filters value traps
- Difficulty
- Moderate
- Time to result
- ~months to results
- Steps
- 5
- Confidence
- 99%
Relative CAPE Sector Rotation evaluates each equity sector against its own valuation history rather than comparing raw valuation ratios across structurally different industries. Calculate each sector's cyclically adjusted price-to-earnings ratio, normalize it relative to that sector's historical range, and rank the market from cheapest to richest. Retain roughly the cheapest half, then apply momentum to remove a sector whose low valuation may reflect continuing deterioration. Equal-weight the final selections and rebalance on a predefined schedule. The mechanism combines mean-reversion potential from relative valuation with evidence from price behavior, reducing reliance on either signal alone. Its expected advantage emerges over a full market cycle, while concentrated growth-led markets can produce extended periods of benchmark underperformance.
Origin
Extracted from Masters in Business during Jeffrey Sherman's explanation of DoubleLine's partnership with Robert Shiller on an enhanced CAPE strategy.
Core principles
- 01Value sectors relative to their own histories
- 02Compare sectors before selecting holdings
- 03Avoid the richest half of the market
- 04Use momentum to reduce exposure to deteriorating value traps
- 05Equal weighting prevents a single selected sector from dominating
How to run it
- 1
Normalize sector valuations
Calculate each sector's CAPE ratio and compare it with that same sector's historical CAPE distribution.
Pro tip Use a consistent history and sector classification throughout the test.
Watch out Raw CAPE ratios are not directly comparable across every industry.
- 2
Rank the opportunity set
Order the sectors from cheapest to richest according to their relative historical valuations.
Pro tip Inspect ties and extreme observations before applying the rule.
Watch out Do not override rankings merely because a popular sector appears expensive.
- 3
Select the cheap half
Discard the richest portion of the market and retain approximately the five cheapest sectors from an eleven-sector universe.
Pro tip Predefine how rounding and sector changes will be handled.
Watch out Changing the cutoff opportunistically undermines the systematic process.
- 4
Filter with momentum
Apply a momentum measure to the cheap candidates and remove the weakest one to control for value traps.
Pro tip Use a momentum window established before examining current results.
Watch out A cheap sector with collapsing momentum may remain cheap for fundamental reasons.
- 5
Equal-weight and rebalance
Allocate equally across the final four sectors and restore target weights on a fixed schedule.
Pro tip Include turnover and taxes when selecting the rebalance frequency.
Watch out Frequent discretionary changes can erase the method's discipline.
In the wild
An allocator ranks eleven sectors by each sector's CAPE relative to its own history. The five cheapest advance to the second stage. A momentum screen removes the weakest candidate, and the remaining four sectors receive equal weights.
→ The portfolio gains systematic value exposure while avoiding the cheapest sector with the poorest price trend.
A cyclical sector appears historically cheap after earnings expectations collapse. It enters the cheapest half but has the worst momentum among the finalists. The filter removes it, preventing valuation alone from forcing an immediate allocation.
→ The portfolio waits for stronger market confirmation before accepting the apparent bargain.
Common mistakes
Comparing raw CAPE ratios
Different sectors have structurally different economics, so each sector should be measured relative to its own history.
Buying every cheap sector
Valuation without a momentum check can concentrate the portfolio in businesses experiencing persistent deterioration.
Judging it over one market phase
A valuation-led rotation strategy can lag during concentrated growth rallies and should be assessed over a full cycle.
Is it for you?
Best for
Long-horizon equity investors seeking diversified value exposure through a transparent rules-based process.
Not ideal for
It is unsuitable for investors who must closely track a capitalization-weighted benchmark over short periods.
From the transcript
“it takes the cape ratio of each sector and compares it to its own history.”
“So you avoid the rich by the cheapest.”
“you apply momentum like any good academic would do to control for the kind of the value trap, and you're left with four and uqually…”
From the episode
Jeffrey Sherman on a Mathematician's Journey Into Finance
Jeffrey Sherman