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Adjusting AA according to PE Ratio
Old 01-14-2014, 12:03 PM   #1
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Adjusting AA according to PE Ratio

I continue to ready daily news reports reminding us that the various PE ratios analysts like to look at suggest we are nearing all time highs, similar to the ratios we saw right before the 2000 and 2008 bear markets. The often quoted Schiller PE Ratio is now at 25.49, when it's historic average has been about 15. It has me wondering if anyone has thought about adjusting their AA strategy based on the various PE ratios that are used to analyze the markets.

For example, if my normal AA is 60/40, would it be unreasonable to say I'm going to keep it 60/40 as long as the Schiller PE ratio stays below 20. Once it goes above 20, I will adjust to 50/50. I suppose this is just market timing, but is it any different than the market timing we do by rebalancing when our AA is out of alignment due to fluctuations in our stock and bond portfolios?

As long as we decide this is our strategy for the long term, is this really market timing? Is it just "tilting"? Or does it make no sense at all to make adjustments to our AA based on PE ratios?
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Old 01-14-2014, 03:51 PM   #2
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2008 had nothing to do with PE.

I have thought of doing this, but there is more than one way for PE's to correct. Sure, stock prices could go down. but they could also stay the same or drift up while earnings increase. And then the timing is still pretty rough. High or low PE's could last for quite a while. And the E part keeps getting redefined, so hardly anyone can agree on PE anymore, or compare it historically.

Of course, I'm 100% equities for the most part, so I've kind of already taken care of the problem.

One big thing to think of is 2008-2009. Did PE's hit bottom with the market bottom? Was that info available in real time, or was it delayed by a quarter or two waiting for earnings info? Were you considering buying or selling near the market bottom?
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Old 01-14-2014, 04:01 PM   #3
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Quote:
Originally Posted by Ready View Post
I continue to ready daily news reports reminding us that the various PE ratios analysts like to look at suggest we are nearing all time highs, similar to the ratios we saw right before the 2000 and 2008 bear markets. The often quoted Schiller PE Ratio is now at 25.49, when it's historic average has been about 15. It has me wondering if anyone has thought about adjusting their AA strategy based on the various PE ratios that are used to analyze the markets.

For example, if my normal AA is 60/40, would it be unreasonable to say I'm going to keep it 60/40 as long as the Schiller PE ratio stays below 20. Once it goes above 20, I will adjust to 50/50. I suppose this is just market timing, but is it any different than the market timing we do by rebalancing when our AA is out of alignment due to fluctuations in our stock and bond portfolios?

As long as we decide this is our strategy for the long term, is this really market timing? Is it just "tilting"? Or does it make no sense at all to make adjustments to our AA based on PE ratios?
You lost me at "I continue to read daily news reports". Trusting mainstream media to provide meaningful information is like trusting the payouts advertised by casinos while believing that either improve your odds.

Yes, it's market timing. Otherwise known as speculation. There's spending, there's investing, and there's speculation. It's a good idea to know the difference between each.
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Old 01-14-2014, 04:27 PM   #4
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My first post as a noobe here. I recently did some research on rebalancing at the bogleheads site. Rule #1 I found is to be comfortable with my AA strategy, which I am. Rule #2 I found is to follow "5/25" based on your AA. Rebalance when either an asset class moves 5% beyond your target allocation percentage -or- when the value within an particular asset class swings 25% from the target amount. The 5% really applies to those asset classes at or above the 20% portfolio allocation mark. The 25% applies to those assets under the 20% allocation mark.

I thought that seemed reasonable. Its not pure market timing. Its more like threshold timing. But it avoids unnecessary rebalancing fees. And the rebalancing you do do satisfies the urge that the market it swinging too far from your liking (a.k.a Asset Allocation).

Back testing seems to indicate it could add a percentage or two to returns over time. But really what most are trying to do is control risk.
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Old 01-14-2014, 05:01 PM   #5
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I don't think adjusting asset allocation based on PE10 is a terrible strategy. It may even be a very good strategy. But I do believe that most of the proponents of such a strategy are closet market timers who would be delighted to reduce their stock allocations just as a severe bear market got underway.

Otherwise, what do they hope to gain? Specifically, what investment are they making with the money they get from selling stocks that they expect to have a superior track record? Cash earns nothing, bonds are subject to interest rate risk, CDs tie up your money for years in return for paltry yields, precious metals may have peaked. It would be extremely challenging to prove to an objective observer that any alternative right now is better than stocks.

What selling stocks does accomplish is to take risk off the table. Even if the alternatives do worse in the long run, there are still a lot of options that aren't as vulnerable to 20%-50% declines in the next few years.

So if you can honestly say that you're willing to give up potentially large future gains in exchange for lowered risk, then go ahead and adjust your stock allocation. It may not work to maximize your profit, but modest selling right now is probably not going to wreck your financial future either.

And there is always the chance that come December you will be able to tell everyone that you saw the crash of 2014 coming and got out just in time.
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Old 01-14-2014, 05:06 PM   #6
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To the OP:

In the end, despite whatever the pundits say on TV or posters here like myself write, you have to do what you feel comfortable with.

There are posters here who consider anyone who holds any modicum of stocks a speculator. Why? Because stocks have risks. They can go down, and there's nothing to guarantee that they will eventually go up. To these posters, investing means CDs, annuities, TIPS.

People who shun stocks have a point, considering that since Jan 2000 up until mid 2013, money invested in S&P500 trailed behind inflation, even with dividend invested. People who made out well in the stock market obtained the gain via trading, either by so called balancing or market timing, a dubious disctinction in my view, but strict buy-and-hold did not work for the last 13 years! Hence, they call stock investors speculators.

As to myself, I hold stocks because I have always been a bull. I deal with the recent rise of the US market by looking for sectors that have been lagging the S&P, and to diversify to countries that have been beaten down lately. This may not work for you, if you are not a slicer-and-dicer. Will I beat the S&P? Time will tell, but it makes me more comfortable with my investments. Or if I do not beat the S&P in the long run but average out the ups and downs, I am still happy.

And by the way, P/E alone does not work well for market timing as an earlier poster pointed out.
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Old 01-14-2014, 05:12 PM   #7
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Originally Posted by Animorph View Post
2008 had nothing to do with PE.

I have thought of doing this, but there is more than one way for PE's to correct. Sure, stock prices could go down. but they could also stay the same or drift up while earnings increase. And then the timing is still pretty rough. High or low PE's could last for quite a while. ...
This is what keeps me from acting on this. We may be nearing some kind of 'peak', but if it just drifts sideways while E catches up with P, then whatever you move into needs to do better than the ~ 2% divs you would get from a broad equity index fund. And it may continue rising for a while from here (I thought it had likely peaked last year!). And then of course, when do you get back in?

Maybe some can do it, I just don't really have the confidence that I can get enough of that right enough compared to doing nothing.

-ERD50
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Old 01-14-2014, 05:20 PM   #8
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Originally Posted by Ready View Post
I continue to ready daily news reports reminding us that the various PE ratios analysts like to look at suggest we are nearing all time highs, similar to the ratios we saw right before the 2000 and 2008 bear markets. The often quoted Schiller PE Ratio is now at 25.49, when it's historic average has been about 15. It has me wondering if anyone has thought about adjusting their AA strategy based on the various PE ratios that are used to analyze the markets.
You can always just go look for yourself. Here's two as of today...S&P 500 PE Ratio
Attached Images
File Type: jpg PE.jpg (62.7 KB, 24 views)
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Old 01-14-2014, 05:51 PM   #9
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Thanks everyone for the feedback. I'm no expert on any of this, so I always value the diverse opinions of this forum.

Midpack - thanks for the graphs. They are very telling. So let's use the Schiller PE Ratio to evaluate the last two bear markets. Using my rule to scale back from 60/40 to 50/50 when PE exceeds 20, I would have pulled back right about 1995. I would have missed out on some tremendous gains from 1995-2000 and would not have restored my 60/40 AA until about 2008, when it went back down to 20 again. Then I would have lost even more money during the 2008 bear market but would have kept my money at 60/40 until about 2010, then pulled back to 50/50 again and missed the rise in markets over the past several years.

So, I think my strategy would have pretty much sucked during the last decade. Well, I guess I won't be winning any Nobel prizes for figuring out the secrets to predicting the stock market. It was worth exploring. Back to 60/40...until something else crosses my path.
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Old 01-15-2014, 04:35 PM   #10
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Originally Posted by Ready View Post
Thanks everyone for the feedback. I'm no expert on any of this, so I always value the diverse opinions of this forum.

Midpack - thanks for the graphs. They are very telling. So let's use the Schiller PE Ratio to evaluate the last two bear markets. Using my rule to scale back from 60/40 to 50/50 when PE exceeds 20, I would have pulled back right about 1995. I would have missed out on some tremendous gains from 1995-2000 and would not have restored my 60/40 AA until about 2008, when it went back down to 20 again. Then I would have lost even more money during the 2008 bear market but would have kept my money at 60/40 until about 2010, then pulled back to 50/50 again and missed the rise in markets over the past several years.

So, I think my strategy would have pretty much sucked during the last decade. Well, I guess I won't be winning any Nobel prizes for figuring out the secrets to predicting the stock market. It was worth exploring. Back to 60/40...until something else crosses my path.

The stock market is designed to keep us humble.
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Old 01-15-2014, 06:04 PM   #11
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My first post as a noobe here. I recently did some research on rebalancing at the bogleheads site. Rule #1 I found is to be comfortable with my AA strategy, which I am. Rule #2 I found is to follow "5/25" based on your AA. Rebalance when either an asset class moves 5% beyond your target allocation percentage -or- when the value within an particular asset class swings 25% from the target amount. The 5% really applies to those asset classes at or above the 20% portfolio allocation mark. The 25% applies to those assets under the 20% allocation mark.

I thought that seemed reasonable. Its not pure market timing. Its more like threshold timing. But it avoids unnecessary rebalancing fees. And the rebalancing you do do satisfies the urge that the market it swinging too far from your liking (a.k.a Asset Allocation).

Back testing seems to indicate it could add a percentage or two to returns over time. But really what most are trying to do is control risk.
Interesting. Welcome to the forum!
I have been using retirement withdrawals to make adjustments to my portfolio. Lately I have been taking money from the "winners". That being the assets that are most overvalued. For equities I use the PE times the book value to get a relative comparison number.
I have no evidence to prove that it is a successful way to go.
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