Embrace the Pain-Bear Market Strategy from Finance Buff

[haha]

Embrace the Bear Market with Overbalancing - The Finance Buff

This method counsels increasing one's % allocation to equities as the equity market falls. I think the principle is good; it would have kept me from over-committing too early last fall. And it would help others who were tempted in the opposite direction from selling out or reducing their equity allocation.

I think a better metric might be some smoothed Price/Earnings ratio. I think an investor as opposed to a speculator is more interested in a gauge of value, than a gauge of what the loss has been, though they are both probably helpful and possibly both should be used.

Ideas?

Ha

 

[ziggy29]

I suppose it might be possible to look at something like where the current PE10 is relative to historical levels and figure appropriate allocations to equities off that. For example, if a PE10 of (say) 15 is about average historically, you might have a "default" 60/40 weighting to equities. As it approaches 20, you might slide it back to 40/60 and as it approaches 25, hold little if any. On the other side, you might go 80/20 when the PE10 is 12, and so on.

I don't know how well such "dynamic asset allocation" based on perceived equity valuations would have held in a backtest.

The problem is that interest rates complicate this; a PE of 12 when T-bills are yielding 2% is an attractive valuation, but a PE of 12 when T-bills are yielding 8% isn't.

 

[FIREd]

I think that the biggest lesson I have learned from this bear market is that it doesn't make much sense to DCA into equities regardless of valuation. The problems I have are: 1) how to establish proper and meaningful valuations (various sources seem to come up with various answers, for example some say stocks are way undervalued right now, while others say stocks are near their long term averages) and 2) at what valuation level do you turn on/off equity purchases. I am currently using value cost averaging for my taxable account but, as I come to realize, this has its limitations as well.

 

[free4now]

Doesn't seem like a safe approach for someone who is living off their portfolio. Increasing your equity exposure to 85% when the market goes down 50% surely will get you well positioned for a recovery, but if things go further south you'll have few options besides jumping out of a window. Kinda like "double or nothing".

 

[kyounge1956]

I suppose it might be possible to look at something like where the current PE10 is relative to historical levels and figure appropriate allocations to equities off that. For example, if a PE10 of (say) 15 is about average historically, you might have a "default" 60/40 weighting to equities. As it approaches 20, you might slide it back to 40/60 and as it approaches 25, hold little if any. On the other side, you might go 80/20 when the PE10 is 12, and so on.

I don't know how well such "dynamic asset allocation" based on perceived equity valuations would have held in a backtest.

The problem is that interest rates complicate this; a PE of 12 when T-bills are yielding 2% is an attractive valuation, but a PE of 12 when T-bills are yielding 8% isn't.

If I understand you (and them) correctly, this is what Ben Stein and Phil DeMuth advocate in their book Yes, You can Time the Market. They suggest use of the 15 year rolling average of P/E (among other statistics)to decide when stocks are expensive and when they are not, and only buying them when they aren't. There are a lot of comparisons of what would have happened if an investor had done this over various historical periods with a one-time lump sum investment or with multiple increments over time. They apply this principle to indexes only, not to individual stocks, and over a long term only (>10 years, 20 is even better). I also don't know how or if the principle would apply to other kinds of investments like bonds or REITs.​

I have been wondering recently whether just buying into a "value stock" mutual fund wouldn't have about the same effect. I have been plugging away at my asset allocation homework, and one thing I discovered looking at the data was that for the periods covered, value stocks always returned more and fluctuated less than either same-size growth stocks or their size category as a whole, and since this was true of all size classes, I assume it's true of the whole market too. That now has me puzzled about why/whether one should buy a broad market index. Why not just go for the value fund? Is it because "past performance is no guarantee", and just because value stocks have always been higher return/lower risk in the past is no reason to assume this will hold true going forward?

 

[FUEGO]

I think it makes sense in principle. The devil is in the details of how you implement the strategy. I guess it isn't a lot different than folks who were thinking about upping their equity allocations when the Dow was hovering around 8000-8500 (thinking how much uglier could it really get).

Or folks (like me) who were already 100% equities considering refinancing the house or getting a home equity loan and investing even more in the market, effectively increasing their equities allocation to 130% or more.

 

[haha]

I think it makes sense in principle. The devil is in the details of how you implement the strategy. I guess it isn't a lot different than folks who were thinking about upping their equity allocations when the Dow was hovering around 8000-8500 (thinking how much uglier could it really get).

Or folks (like me) who were already 100% equities considering refinancing the house or getting a home equity loan and investing even more in the market, effectively increasing their equities allocation to 130% or more.

My all time high equtiy allocation was about 120%. But I didn't include my mortgage in the calculation. Also didn't include commodity futures, which might have pushed the leverage up quite a bit. I am too old for this now, and I do not see such a total wipeout that I would do it even if I were employed securely.

But really, all you are doing is upping your bet on yourself as a judge of values. Good character reference I'd say.

Ha

 

[thefinancebuff]

Doesn't seem like a safe approach for someone who is living off their portfolio. Increasing your equity exposure to 85% when the market goes down 50% surely will get you well positioned for a recovery, but if things go further south you'll have few options besides jumping out of a window. Kinda like "double or nothing".

As the author of the referenced "strategy" I agree with you. I'm aspiring for ER, not there yet. Most of the overbalancing is done with new cash. This is also similar to value averaging. In value averaging, almost all new cash goes to stocks when the stocks go down. I also want to report that this has not worked out yet. I would have more money now if I stayed at 60/40. I have plenty of time though.

 

[FIREd]

Most of the overbalancing is done with new cash. This is also similar to value averaging. In value averaging, almost all new cash goes to stocks when the stocks go down.

I have followed that strategy since 2007. But I am finding some limitations. For example, in October 2007, as the stock market peaked, most new money for that month was invested in fixed income. Then in November 2007, as the stock market started declining, I switched and started investing most new cash in the stock market. Yet stocks were not exactly cheap at the time. They were just relatively "cheaper". By following this strategy, I started buying stocks too soon. So I think that valuation has to play a role in the decision making process. If stocks decline but valuations are still high, then should your cash really go to stocks? Or should you hold off until valuations become more attractive?

 

[thefinancebuff]

I have followed that strategy since 2007. But I am finding some limitations. For example, in October 2007, as the stock market peaked, most new money for that month was invested in fixed income. Then in November 2007, as the stock market started declining, I switched and started investing most new cash in the stock market. Yet stocks where not exactly cheap at the time. They were just relatively "cheaper". By following this strategy, I started buying stocks too soon. So I think that valuation has to play a role in the decision making process. If stocks decline but valuations are still high, then should your cash really go to stocks? Or should you hold off until valuations become more attractive?

I like mechanical rules better than subjective criteria. If you are going to use valuation, pick your metrics ahead of time and write them down. Otherwise there will be too much second-guessing. "Is it low enough now? What about tomorrow?" Slippery slope to looking for the bottom.

 

[Dennis]

Well, being Financialy able to retire, I have to ask myself Why Bother? If I'm very happy making my 7% or whatever apy on my current portfolio for the past several yrs and Many pro's are advising Not to allow 08' to influence change, but use past 10 yrs instead, if you have to change for the sake of change.. Why would I want to Take on the added Risks of moving out of my "comfort Zone" and into " the Dark Side, that has proven to be unstable at the least..?

If John Boggle starts Talkinga bout his changing his % allocattions and more into his Equites? And some others I follow say they are also? Then I might consider it as well..

However, for those still struggling to become able to ER? I made a killing in the last Bear market with Betting on Inverse Funds and then in early 03' moving that Profit into Small caps and Small caps Bull /Leverage funds..( UAPIX) but just for the avearge Recovery period of 18 -24 mos and then plan to sell. Now wether this will work this time around? I don't know, but sure is shaping up like it will..and just for adding to my charitable trust, I took 1% of my $ and have done this again Last Yr and now in that same UAPIX since 11/21/08'.. Hope it works again... Who knows..but, so far, so good..

"The things that come to those who wait will be the things left by those who got there first."

 

[FIREd]

I like mechanical rules better than subjective criteria. If you are going to use valuation, pick your metrics ahead of time and write them down. Otherwise there will be too much second-guessing. "Is it low enough now? What about tomorrow?" Slippery slope to looking for the bottom.

I do like mechanical rules too. I currently use a spreadsheet to determine how to invest new money, so there is no guessing involved: plug in the current numbers, enter how much new money you want to invest and the spreadsheet spits out amounts to be invested in stocks, bonds, etc... No emotions or overanalyzing involved. And that's why I struggle with this idea of "valuation". Logically, I know valuations should be taken into account, logistically, it's a bit of a nightmare. Stock market valuations seem hard to pin down. And then, as pointed above by Ziggy, a P/E of 12 is not necessarily "cheap". So it's going to be hard to come up with a mechanical rule.

 

[FUEGO]

Another problem of relying strictly on valuations or other fundamental metrics is non-execution risk. Say you wait for PE 14 to invest all your cash into equities. Down, down, down the market goes. All the way to PE 14.1. Then back up, then back down, but never back below 14.1. Then it takes off to PE 17-20 for the next ten years. You're left in inflation, maybe inflation+1% investments for those ten years still waiting for PE 14.0. In the meantime, the stocks are growing earnings at an average of 3% above inflation each year and paying 2.5% dividends. Leaving your cash holdings in the dust.

 

[haha]

Another problem of relying strictly on valuations or other fundamental metrics is non-execution risk. Say you wait for PE 14 to invest all your cash into equities. Down, down, down the market goes. All the way to PE 14.1. Then back up, then back down, but never back below 14.1. Then it takes off to PE 17-20 for the next ten years. You're left in inflation, maybe inflation+1% investments for those ten years still waiting for PE 14.0. In the meantime, the stocks are growing earnings at an average of 3% above inflation each year and paying 2.5% dividends. Leaving your cash holdings in the dust.

True enough, but most would not do an all or nothing plan like this. And to be inclusive, last year's most successful investors on this board, including some who have since left, were 100% or close in fixed income. Not investing in equities might give a slow death (at least when TIPS are not available at good prices) but badly timed equity investing can really bash your head in.

For a retiree I think the most rational plan, which someday I hope to be rational enough to follow, is to establish bounds- say 20/80 to 80/20, (emergency funds not considered), make a farly steep transfer function based on a clearly stated and understood valuation function, and follow it.

For me it be would easy enough when interest rates were moderate to high. When rates are artificially pushed down as they are at present, I dunno. I think Bernanke and Co. would do anything to savers, so the past may not be a good guide to what you can expect from government fixed income.

Ha

 

[FUEGO]

Ha,

I would suggest mechanical rules would work well in sample (of historical market returns) but wouldn't do nearly as well out of sample in the future. But I agree that any changes based on relative valuation should be done gradually as thefinancebuff suggested in his article. Something like 5% increase to equities allocation for every 10% drop in market value. That way, whether we see a 10, 20, or 30% drop in values, you are increasing your equities allocation at a time when equities are relatively cheap. Since I'm 100% equities, I'm currently cash poor so don't have the "problem" of whether to increase my equity allocation. Although I do "market time" to a certain extent by going a little overweight in asset classes that really got pounded (this year these were Emerging markets, small cap international and international and domestic REITs). Ahh, the silver lining in the great volatility cloud.

 

[audreyh1]

Yes, I'm considering a similar strategy, but in the opposite sense - to rebalance to a lower equity allocation after a positive year or two, with the simple assumption that the market is "relatively" inflated after a positive run. Then, once the market has a bad year (or "corrected"), I'll rebalance to a higher equity allocation.

I don't intend to make large changes in the equity allocations, just a few percent, so this action if probably not worth the trouble. But maybe it'll make me "feel" better - LOL!

Audrey

 

[haha]

Ha,

I would suggest mechanical rules would work well in sample (of historical market returns) but wouldn't do nearly as well out of sample in the future. But I agree that any changes based on relative valuation should be done gradually as thefinancebuff suggested in his article. Something like 5% increase to equities allocation for every 10% drop in market value. That way, whether we see a 10, 20, or 30% drop in values, you are increasing your equities allocation at a time when equities are relatively cheap. Since I'm 100% equities, I'm currently cash poor so don't have the "problem" of whether to increase my equity allocation. Although I do "market time" to a certain extent by going a little overweight in asset classes that really got pounded (this year these were Emerging markets, small cap international and international and domestic REITs). Ahh, the silver lining in the great volatility cloud.

The only difference I am proposing is to use a valuation metric, rather than a % down from top.

Ha

 

[Dawg52]

But really, all you are doing is upping your bet on yourself as a judge of values. Good character reference I'd say.

Ha

That's the problem......

 

[NW-Bound]

The only difference I am proposing is to use a valuation metric, rather than a % down from top.

Ha

That still does not solve all the problems, because what considered as the normal P/E ratio has been changing with time.

During the long bull market of the 90s, we had the phenomenon called "P/E expansion" that could have locked us out of the market, if we insisted on the lower P/E of earlier decades. In fact, some old-fashioned market mavens were derided then as permabears, since they kept calling the market as too expensive.

The dynamics of the market, as I described in another thread, makes it difficult to totally rely on old historical data as a guide.

 

[haha]

That still does not solve all the problems, because what considered as the normal P/E ratio has been changing with time.

During the long bull market of the 90s, we had the phenomenon called "P/E expansion" that could have locked us out of the market, if we insisted on the lower P/E of earlier decades. In fact, some old-fashioned market mavens were derided then as permabears, since they kept calling the market as too expensive.

The dynamics of the market, as I described in another thread, makes it difficult to totally rely on old historical data as a guide.

There are optimizers, and satisficers. I am one of the latter.

It is rare that there isn't one or more reasonable investment opportunities at any given time. Pick some. If none present themselves, wait. Your example of the nineties is a good one for my point. During the late 90s, the zenith of the bull market, commodity stocks and oil and gas were at extreme lows.

Someone will undoubtedly shout "But diversification!" True enough, but how diversified is a guy who owns a 7-11?

Ha

 

[audreyh1]

Here is one of many interesting metrics. This one is computed by Morningstar and only goes back to 2000. Morningstar.com: Market Valuation Graph

Audrey

 

[haha]

Here is one of many interesting metrics. This one is computed by Morningstar and only goes back to 2000. Morningstar.com: Market Valuation Graph

Audrey

Very intersting.

Value Line publishes a similar metric with a very long successful history. It is always optimistic, but with an unchanging bias. I'll copy the page next time I am at the Central Library and post about it. It is expressed similarly to the one you posted, as average % gain to full value for their universe.

Where I used to live I could get access to the V.L. Survey more easily and I used this as a very helpful long term sanity check on what i wanted to do. You who live in affluent suburbs have much better investment resources in your libraries than in most big cities.

Ha

 

[FIREd]

Here is one of many interesting metrics. This one is computed by Morningstar and only goes back to 2000. Morningstar.com: Market Valuation Graph

Audrey

I also found this graph yesterday as I was googling "stock market valuation". The interesting part to me was that, based on those market valuation data, one should have stopped buying equities in late 2002, just after the market bottomed, and should only have started buying equities again in early 2007, right before the market peaked. That's a long time to be sitting on your hands and not investing any new money in the stock market.

 

[NW-Bound]

During the late 90s, the zenith of the bull market, commodity stocks and oil and gas were at extreme lows.
Ha

What you are saying is to look into sectors that are cheap relative to the market. This, sir, I totally agree with. Sector rotation is the game that I try to play.

Yes, I still remember the time when gas at Costco was 99c. It must be in 1999, or early 2000. But I was still drunk from the tech Kool Aid then. Only in 2003 that I realized my folly, and got myself some energy stocks. Nice, nice gains... Got stopped out of them, and now slowly buying back.

Crazy Kramer, despite what we think of him, is right that "there is always a bull market somewhere". But he has not proven to be a reliable detector of that bull market.

 

[haha]

I just read "How Morningstar Values Stocks". They use a DCF based technique. I am not sure whether they specify the discount rate that they use for any given analysis.

This shuld be fairly robust, but one would need to see how their expectations compared to how it worked out for a longer period. As Firedreamer pointed out, so far it isn't clear that it would have been useful when used as a metric for equity allocation.

Ha