Wade Pfau, Ph.D., CFA

Is a High CAPE Cause for Alarm? Part 2: Valuation-Based Asset Allocation

In my last post, I discussed the origins of the PE10 (a.k.a. cyclically-adjusted price-earnings ratio, or CAPE) and how it has been used to map market performance. Discussion around PE10 focuses primarily on how to adjust expectations about future stock market returns based on its value. A more controversial topic is whether it is beneficial to adjust strategic asset allocation in response to where PE10 is currently situated. Can otherwise passive and conservative long-term investors exploit PE10 to obtain improved retirement planning outcomes? Will it perform better than a fixed asset allocation strategy with the same average allocation to stocks?

Strategic asset allocation involves deciding on an allocation to properly balance risk and return objectives after considering several factors (i.e. capital market expectations, age, job stability, existing wealth, planned expenditures, risk tolerance, and other factors affecting the willingness and ability to bear risk). While most everyone would agree that valuations matter, the question remains as to whether individuals with long-term horizons can hope to act successfully on information about valuations. Should market valuations, through their effect on capital market expectations, be added to the list of characteristics individuals consider when determining their asset allocation?

As with all areas of investing, the long-term focus is important. Historical data shows market valuation levels tend to revert to their mean over long periods of time. When PE10 is low, markets tend to exhibit mean reversion (returning PE10 to its mean) and relatively higher future returns can be expected.

We have historical evidence to suggest that mean reversion can be expected at some point, but it most certainly cannot be predicted. Since the precise timing of mean reversion is entirely random and unpredictable, expecting the result to occur in the short-term is unwise. One internet blogger has been using PE10 to predict a 65% drop in the S&P 500 by the end of 2015. This is not how the concept should be applied.

These investigations are grounded in the notion that attempting to beat the market in the short run is futile. It can take years for the mean reversion to happen. Can patient individuals find a strategy to take advantage of this mean reversion in market valuation levels?

The suggested approach is to lower stock allocation when the PE10 is deemed to be high, and increase stock allocation when it is considered low. As Lucile Tomlinson wrote in her 1953 book Practical Formulas for Successful Investing, “A Variable Ratio formula provides for smaller percentages of stocks in high market areas, where the risk of owning stocks is greatest, and for larger percentages in low market areas, where the risk of loss is bound to be considerably less” (167). Stock formula plans were created to serve as mechanical rules that avoid regret and prevent increasing stock allocations when prices are at their peak, or panicking and selling stocks when prices are at their trough.

Investigations of valuation-based asset allocation enjoy a long history. Benjamin Graham and David Dodd used CAPE (I do not abbreviate it as PE10 for them, since they weren’t specific about using exactly 10 years) in 1934’s Security Analysis to suggest a stock allocation of 50% when CAPE is between 2/3 and 4/3 of historical value. They say to increase stock allocation to 75% when CAPE drops below 2/3 of historical value. When CAPE goes above 4/3 of historical value, they recommend decreasing stock allocation to 25%. These numerical bounds correspond to evolving PE10 values of approximately 10 and 21 over time.

I have also investigated this matter in two published articles: “Long-Term Investors and Valuation-Based Asset Allocation,” from the August 2012 issue of Applied Financial Economics, and “Safe Withdrawal Rates, Savings Rates, and Valuation-Based Asset Allocation,” from the April 2012 issue of the Journal of Financial Planning.

Though published later on account of the vagaries of academic publishing, I wrote the August 2012 article first. That article , was written in response to studies that considered market-timing allocation strategies jumping between two extremes: 100% stocks and 100% cash. I found that most every permutation of valuation-based asset allocation strategies based on PE10 demonstrates strong potential to improve risk-adjusted returns for conservative long-term investors. Such valuation-based strategies provide comparable returns as 100% stocks, but with substantially less risk according to a wide variety of risk measures.

Meanwhile, valuation-based strategies provide comparable risks and the same average asset allocation as a 50/50 fixed (with rebalancing) asset allocation strategy, but with much higher returns. After going over the data, I came to the conclusion that making asset allocation adjustments based on PE10 can improve risk-adjusted returns for conservative long-term investors.

In “Safe Withdrawal Rates,” I sought to apply the concept more directly to personal finance problems using a more realistic range of asset allocation adjustments. As a case study, I compared a fixed 50/50 asset allocation strategy against the 2/3 and 4/3 bounds strategy introduced by Graham and Dodd (Figure 3).

While the fixed 50/50 allocation remains the same throughout, Graham and Dodd’s strategy sees several variations. Between 1871 and 1914, both strategies share the same allocation in every year except 1899 (as I stated before, PE10 are not calculated until 1881, so I assume the valuation-based strategy uses 50/50 for 1871-1880). Between 1915 and 1944, asset allocation changes frequently. From 1944 to 1961, they stay at 50/50. For six years in the 1960s, the valuation-based strategy uses a lower stock allocation, and from the mid-1970s to mid-1980s, the tendency is toward a higher stock allocation. From 1985 through 1992, the allocations return to the middle. As the market booms in the 1990s the valuations strategy uses a lower stock allocation for all years between 1993 and 2008, except 1995. By 2011, valuations rose to the high level again, where they have since stayed.

Figure 1: PE10 Historical Data with Graham and Dodd Asset Allocation Decision Rule

The data shows that valuation-based asset allocation strategies increased the worst-case sustainable spending rate for retirees by 17%. In addition, necessary savings rates to meet retirement spending goals in the worst case from history fell by 20%. Valuation-based strategies have demonstrated historical success to lower savings rates and increase retirement withdrawal rates.

My claim for historical success will be controversial — at least as to whether I have effectively avoided look-back bias. Some may wonder if taxes and transaction costs would overturn the results, or whether such success can be expected to continue in the future. Look-back bias refers to the idea that it is naturally easier to find specific asset allocation strategies which work when applied to past data (similar to the idea of playing Monday Morning sports fans in football). I adopted the original Graham and Dodd strategy as a way to avoid this bias as much as possible. Also, index funds did not exist until the 1970s, making it quite costly to implement these strategies in the past, and the fact that they could be implemented more easily now could make them less likely to work.

Will these strategies continue to work in the future? No one can say for sure. Some people swear these strategies can and do work, while others caution against trusting the PE10. One reason some say to be wary is that changing accounting standards of how earnings are calculated explains why today’s PE10 does not line up with its own historical values. It may be that we are in a period of anomalous average earnings as the effects of the financial crisis are still felt.

William Bernstein has written about the paradox of wealth, which is that returns on capital tend to decrease as societies become wealthier. He tracks this trend back to the middle ages. If this trend continues, we should expect PE10 to center around a higher level than in the past as the returns on capital fall, suggesting that a steep decline in stocks is not likely as PE10 will not return to its historical average. A related argument along these lines is that low interest rates could also justify a higher value of PE10 than otherwise.

Ultimately, you have to be comfortable with your investment strategy, so this is not for everyone. Implementing the valuation-based allocation strategy requires a certain disposition that is comfortable with contrarian investing — acquiring lower stock allocations when people are most giddy about stocks, and higher stock allocations when panic has set in for the typical investor.

Regardless of an investor’s disposition, the rules outlined here are a better alternative for those adjusting allocation in response to market valuations than emotion-based and arbitrary market-timing decisions. Generally, investors tend to give in and increase stock allocations near a market peak and then panic and decrease allocations after a market drop, which is the opposite of what should happen. Incorporating valuation-based asset allocation in an Investment Policy Statement can provide the psychological resolve to weather big market drops, especially considering that such drops tend to occur when valuations are high, so the investor would already be at a lower stock allocation.

If nothing more, the historical results for valuation-based asset allocation could be used to help investors stay the course rather than move in the wrong direction with their asset allocation as stock prices and valuations naturally fluctuate over time. Nonetheless, if one chooses to not make extreme changes to allocations in response to PE10, I would anticipate the strategy should still support higher long-term returns without adding much in the way of risk regarding the sustainable standard of living.

2 Comments

  1. […] part two, I will consider how much weight the PE10 should hold in making investment […]



  2. […] further withdrawals were made from the remaining asset class, for as long as it lasted. (Note Wade Pfau and Michael Kitces have also studied CAPE in retirement […]



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