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How rising Wall Street star Jeff Sherman uses 'CAPE' to beat the market

Even as the stock market continues to reach new highs, DoubleLine Capital’s deputy CIO Jeffrey Sherman sees undervalued sectors.

Like many market participants, Sherman follows Robert Shiller’s cyclically-adjusted price-earnings ratio (CAPE), which takes the S&P 500 (^GSPC) and divides it by the average of ten years worth of earnings. If the ratio is above the long-term average of around 16, the market is considered expensive. CAPE is currently around 31.

Sherman, who manages the DoubleLine Shiller Enhanced CAPE (DSEEX) fund, identifies opportunities by looking at the CAPE ratios for each of the ten sectors of the S&P 500 relative to each sector’s historical average.

“What you find is even a market today that has this elevated CAPE ratio — and it is above average — there are still sectors which trade below their historical averages,” Sherman told Yahoo Finance in the video above.

Using this CAPE framework, Sherman takes the five cheapest sectors and then applies a filter to take out the sector with the worst rate of return over the last year. In other words, he throws out what he considers to be the value trap.

Right now, the fund’s sector positions include consumer discretionary (XLY), industrials (XLI), technology (XLK), and healthcare (XLV). At this time, the energy sector has been the value trap.

The DoubleLine Shiller Enhanced CAPE fund (DSEEX) has outperformed the S&P 500 since its inception in late 2013.

Of the remaining five sectors, financials are the most overvalued in the market. The bank stocks have been on a tear since the election of Donald Trump.

“With the election, it’s funny. It kind of reminds me of the Obama campaign – it was a lot of change for change and a lot of ideas of change in the administration — tax reform, health care reform, deregulation,” Sherman said. “And what industry benefits the most from that? And so what you saw is the financial sector going on a tear post-election. In fact, it’s been one of the best performing sectors of the market.”

Financials have performed well. But Sherman notes earnings haven’t caught up significantly.

“And so again, by using a long-term earnings perspective, it makes this being the financial sector being the most overvalued of all the sectors of the S&P 500. Again, according to this relative CAPE metric.”

Since the fund’s inception in late 2013, the DoubleLine Shiller Enhanced CAPE fund has outperformed the S&P 500 (^GSPC), a feat very few fund managers are able to achieve. At the time of this writing, the fund’s year-to-date return was 15.08% compared to the S&P 500’s 14.40% gain.

Listen to the full interview:


Julia La Roche is a finance reporter at Yahoo FinanceFollow her on Twitter.