Using Shiller PE to Time the Market

[CCdaCE]

In the paper : Investing for Retirement: The Defined Contribution Challenge -- Ben Inker and Martin Tarlie , currently at GMO LLC - Home

They talk about the correlation between the Shiller P/E value and future returns.

At 1 year, it's about a 20% correlation,
At 5, almost 45%,
at 10 years, 60%,
At 20, about 70%.

See chart 10 on pg. 7.

So, like others have said, not a perfect system. But, overall, this paper addresses a lot of the variables of asset allocation, and a thought provoking discussion of valuation, timing/timeframes, returns simulations, etc.

-CC

[target2019]

Quote:

Originally Posted by gcgang https://www.gmo.com/America/CMSAttac...8UAGtIt6BuU%3d Above is a Feb 2014 article from GMO, basically concluding that CAPE has been a way to determine valuations, and that the US markets are in overvalued territory, European and especially Emerging offer better value. While CAPE doesn't predict what the market will do in the near term, it has had a pretty good record at helping figure out the probabilities of what my biggest concern is at this point in my life, suffering a significant "drawdown". Low CAPE, very low chance of a big decline, high CAPE... Sent from my iPad using Early Retirement Forum

Good read. Thanks for highlighting.

Montier uses five measures (one is PE10), and concludes that U.S. market is overvalued, and expectation is - 1.1 return over the next 7 years.

[REWahoo]

Quote:

Originally Posted by target2019 Good read. Thanks for highlighting. Montier uses five measures (one is PE10), and concludes that U.S. market is overvalued, and expectation is - 1.1 return over the next 7 years.

You'll have to follow up in 2021 to see how he did. Wonder if he's any better at predicting markets than the sad track record this bunch has?

[target2019]

Quote:

Originally Posted by REWahoo You'll have to follow up in 2021 to see how he did. Wonder if he's any better at predicting markets than the sad track record this bunch has?

Probably best that you mark this as something to check.

[target2019]

Jim Otar has a tactical allocation discussed in his popular book. One approach would take the 6-year average for an equity fund, and compare that to the end of year result. If the result is higher than the 6-year average, time to go defensive for the coming year in that equity fund. Now what he means by defensive is open to interpretation. I don't think he means going all to cash. He also cautions that there will be false signals, and you'd have to accept those as part of the strategy.

[dallas27]

The symphony of experts who are predicting lackluster returns for years to come is the exact reason I believe we'll see just the opposite. Show me a time in financial history that the groupthink was ever right.


Sent from my iPhone using Early Retirement Forum

[Lsbcal]

Quote:

Originally Posted by dallas27 The symphony of experts who are predicting lackluster returns for years to come is the exact reason I believe we'll see just the opposite. Show me a time in financial history that the groupthink was ever right. Sent from my iPhone using Early Retirement Forum

Well a lot of people didn't care for Germany in the mid 1930's.

Still, I agree with your general idea!

[dallas27]

Quote:

Originally Posted by Lsbcal Well a lot of people didn't care for Germany in the mid 1930's. Still, I agree with your general idea!

I did say "financial history". And to be fair, the group think was that Germany was someone else's problem, until it was everyones.


Sent from my iPhone using Early Retirement Forum

[sengsational]

Quote:

Originally Posted by Totoro What Greenblatt wrote in his "little book" stuck with me. Approaches that work only on timescales of 5+ years (sometimes even 3) tend to keep on working because most money managers get fired/hired on an annual performance basis. Even most private equity firms rarely have a horizon beyond five years. ..

Based on your mention, I got the book from the library. It was re-released in 2010, five years after the original publication. The new title is "The Little Book That STILL Beats the Market".

I read a couple of old threads on this board, but it seems that nobody writing then had read the book. Having " magic" in the title was enough to sour them.

Greenblatt seems like an academic that wants to show intellectual prowess, not just someone who wants to sell books to make money. Wanting to be the guy to give the small investor a tool to do better in the tough world of investing is not quite the same as someone hyping a scheme.

I don't think this technique is simply data mining; I think it probably would work if an investor was able to stomach the many transactions and keep at it, even when it falls behind the market as a whole. But exactly as you and Mr Ha said, the reason why institutional investors can't use the technique is that the wait for the payback can be years, and they'd drop all their customers after a few months of not keeping up.

[Lsbcal]

Quote:

Originally Posted by dallas27 I did say "financial history". And to be fair, the group think was that Germany was someone else's problem, until it was everyones. Sent from my iPhone using Early Retirement Forum

Mea culpa.

[Totoro]

Quote:

Originally Posted by sengsational I don't think this technique is simply data mining; I think it probably would work if an investor was able to stomach the many transactions and keep at it, even when it falls behind the market as a whole.

I also believe there is something to it, so I am running an experiment with $30k

So far (six months in) it's running at a small overall loss due to a few dramatic losers in the ten share portfolio. Going to keep running it though for at least three years.

[sengsational]

Quote:

Originally Posted by Totoro I also believe there is something to it, so I am running an experiment with $30k So far (six months in) it's running at a small overall loss due to a few dramatic losers in the ten share portfolio. Going to keep running it though for at least three years.

I'm tempted to do something similar!

There is a guy on motley fool CAPS "trackjgreenblatt" that has a record going back to 2007, I think. That tool doesn't handle re-buys very well, so I couldn't derive his IRR, but he is ranked in the mid 80th percentile.

[Texas Proud]

Can not see it now and am not going to look it up...

I read an article last night before going to bed from Shiller saying that even though the ratio is high it might not mean much.... he said there are only 3 data points and that is not enough to say there is going to be a crash... there is a possibility that earning will grow enough to bring down the ratio instead a drop in price...

So if the person who developed this ratio is saying not to use it as a market timing tool, I do not see how anybody else can say that it should be used as one...

[haha]

Quote:

Originally Posted by Texas Proud Can not see it now and am not going to look it up... I read an article last night before going to bed from Shiller saying that even though the ratio is high it might not mean much.... he said there are only 3 data points and that is not enough to say there is going to be a crash... there is a possibility that earning will grow enough to bring down the ratio instead a drop in price... So if the person who developed this ratio is saying not to use it as a market timing tool, I do not see how anybody else can say that it should be used as one...

Easy to explain. Anybody can say anything they want to, as long as it does not upset our various spy agencies.

Ha

[Lsbcal]

Current PE10 = 25.7

From Sept 2003 to Dec 2007 the SP500 went up 10.9% on an annual basis.
During those years:
PE10 average = 26.2
PE10 minimum = 24.7
PE10 maximum = 27.7

Obviously PE10 during those 4+ years was not a market timing tool.

[RobLJ]

Using Shiller PE as an investment timer is a bad idea--see Hussman funds.
Using it to tweak investment allocations (from over to comparatively undervalued) is not a bad idea--I did a version of that in 1999-2002 and in 2006-8 and am now rebalancing to foreign stocks, but YMMV.
I see Dallas made my point above, which was to consider pulling some or a lot of gains from overvalued markets to undervalued, which would be Emerging Market, Europe, perhaps China, etc, perhaps on a slow and steady periodic reallocation. If the US continues to soar, you will continue to benefit on your prior allocation but also have side bets from the reallocations. I've done this over the last 14 years, which smoothed out both the high years and the low years since there generally was an undervalued market jumping--other than late 2008/9.

The market can stay irrational longer than you remain solvent or sane. (Or earnings can accelerate to justify the PE--the essence of growth investing.) And the 2008 crash was a once or twice in a lifetime anomaly, which raises some caution in the Schiller 10 data--one would think. Will Texas score <10 points against OU every year and get beat by 50 points?

Using Schiller PE10 to tweak a safe withdrawal % guide is an interesting thought that makes intuitive sense, although I'll think about it more.

[samclem]

Resurrecting this thread, sorry.
It turns out that Kitces and especially Pfau have looked at using PE10 as a means to adjust portfolios for reduced risk/greater return, and there appears to be something useful here.

As many people know, this idea is far from new. Benjamin Graham suggested such a weighting scheme. In a 2011 paper, Dr Pfau did some analysis of Graham's system (he used PE10 as the valuation metric, of course it didn't exist when Graham and Dodd did their work)

From this paper:

Quote:

As a case study, I will compare a fixed 50/50 asset allocation strategy against a strategy introduced by Graham and Dodd (1940), in which investors maintain a 50/50 asset allocation when valuations fall within a range between 2/3 and 4/3 of their historical average value; the stock allocation is 75% when valuations are less than 2/3 of their average and 25% when valuations are more than 4/3 of their average. These numerical bounds correspond to evolving PE10 values of approximately 10 and 21 over time

The results were impressive. Compared to a static 50/50 rebalanced portfolio, on average retirees using the valuation-shifting strategy could have afforded SAFEMAX withdrawal rates about 1/2% higher, and it was 2% higher for some retirement years. That might not sound like a lot, but if we were planning to take 4% per year, that's 12% to 50% increase in allowable spending. The best part is that it is achieved with less portfolio volatility.

Pfau didn't try to datamine and reverse-engineer the signal points or weightings, he just used what Graham proposed.

In this paper (Be sure to pull up the second available dowload--"35006"--it has been updated), Pfau takes a look at a previous popular study that had found negative results from PE10 timing. Pfau found the opposite--jumping from 0% to 100% stocks (to short-term commercial paper) based on 4 possible timing signals each produced average geometric returns better than 100% stocks. More significantly for most of us, he looks at other AA "spreads" centered on 50/50 (10:90, 20:80. 30:70, 40:60) and how an investor would have done (see Table 3). In general, the volatility of the "timing" portfolio was higher than the fixed 50/50 portfolio, but the average geometric return was from .3 to 1.5% better per year. The Sharpe ratio (a measure of how much risk is rewarded) was better for all the valuation-based portfolios than for the fixed 50-50 portfolio.

Pfau and Kitces collaborated on this piece. Similar positive results for varying the portfolio weightings based on valuation. As we have recently discussed elsewhere, they also found that using govt bills rather than commercial bonds proved to be much more effective during times that stocks were overvalued by historic standards (as they are today). Rising equity allocations later in retirement are also indicated when a person retires at a time of high stock valuations (i.e. it's best to start with a higher % of bills at first, to get past the point where sequence of returns risk could scuttle your plans if the stock market crumps--and crumping is more likely if you retire when valuations are high.

I think there's something to this. And it is intuitive--own less stocks when they are more likely to take a plunge. The historical record seems pretty solid, and it isn't highly dependent on picking just the right trigger points or AAs. Pfau even showed it was effective in the Japanese market.

DMT? Maybe. But hardly day trading or reacting to the 200 day moving average. Most of these schemes would trigger a change in allocation on average intervals of 4-5 years, but the wait can be a lot longer than that. PE10 has very little predictive ability on a year-to-year basis, and (as noted previously here) that may shield these techniques from being used by many advisors/MFs, and even institutional investors--you'll be "wrong" for years at a time, and that's not good for a career. Even if the technique works well over the long term.

[samclem]

Quote:

Originally Posted by CaliforniaMan +1 The big problem with all of these in my opinion is that there is no way to get any meaningful historical statistics not to mention reasonable projections of future probabilities. No way to do a FIRECalc type measurement for example on Greece or Russia or even China. Might be some great values here but at this point in my life they are not for me.

+1. As an alternative to US bills/bonds as a place to move the money when US equities are overvalued, I don't think foreign equities are a good idea. We're trying to get ahead of the future US market with these AA shifts in response to today's (US) PE10--what's cheap or expensive in other markets today might even be negatively correlated to what happens when the US market dives--maybe they dive worse, even if their valuations today are favorable. I'd be more content to park money in USG bills and wait.

But what to do about shifting the allocations of non-US equities in our portfolio? Shift them into bonds/bills (US? Foreign?) when we reduce US equities? Keep them constant at a fixed % of portfolio and just use the shifting-with-PE10 strategy with US equities? As a first guess: Based on the apparent increased correlations between US and foreign equities, I'd reduce my foreign holdings along with US ones when US PE10s are high. And I'd probably stick with USG bills rather than foreing ones--if there's a "flight to quality", the money will probably come to the US again (I hope!).

[Lsbcal]

Quote:

Originally Posted by samclem .... But what to do about shifting the allocations of non-US equities in our portfolio? Shift them into bonds/bills (US? Foreign?) when we reduce US equities? Keep them constant at a fixed % of portfolio and just use the shifting-with-PE10 strategy with US equities? As a first guess: Based on the apparent increased correlations between US and foreign equities, I'd reduce my foreign holdings along with US ones when US PE10s are high. And I'd probably stick with USG bills rather than foreing ones--if there's a "flight to quality", the money will probably come to the US again (I hope!).

I tend to keep US/international ratios constant when adjusting the equity/bond mix. From my studies equity returns are much more correlated to the yield curve then to PE10. I too would stick to US bonds as the bonds are there for capital preservation with only modest hoped for real returns.

[big-papa]

Quote:

Originally Posted by CCdaCE In the paper : Investing for Retirement: The Defined Contribution Challenge -- Ben Inker and Martin Tarlie , currently at GMO LLC - Home They talk about the correlation between the Shiller P/E value and future returns. At 1 year, it's about a 20% correlation, At 5, almost 45%, at 10 years, 60%, At 20, about 70%. See chart 10 on pg. 7. So, like others have said, not a perfect system. But, overall, this paper addresses a lot of the variables of asset allocation, and a thought provoking discussion of valuation, timing/timeframes, returns simulations, etc. -CC

Good article - thanks for the link! There are those of us who don't use the SP500 and I have yet to find PE10/CAPE for other US based market cap/valuation based indices . Yes, there is correlation from them back to the SP500), but I'd bet that given that other indexes are twice removed, I suspect that the correlation to future returns is likewise reduced as well. Wonder if Fama-French have the ability to extract it from their work?