Using Shiller PE to Time the Market

[Running_Man]

Then what good is it And why are people talking like it IS a market timing tool?


Finally, what does it mean.... if it means the market is overvalued, then why not market time...

The timing is in a multiyear mode of overvaluation beginning to recede by Schiller PE hitting a peak and then falling from that peak once it has hit an extremely overvalued level or undervalued level. It works like housing pricing- throughout the 2000's prices stayed high for years, it was only once they began a little fall, which was thought to be minor and inconsequential that the selling picked up steam and eventually fell to levels that were a great value. People didn't sell their houses because they thought they were going to continue to gain value. Many instead just had to give their houses to the bank in the end.

Works the same with stocks, most investors do not market time with it since the overvaluation typically happens at end of a long bull market and investors are more fearful of missing a bull move than of buying properly valued stocks.

 

[Texas Proud]

Should have said "short term" timing tool. Seemingly good long term.


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The timing is in a multiyear mode of overvaluation beginning to recede by Schiller PE hitting a peak and then falling from that peak once it has hit an extremely overvalued level or undervalued level. It works like housing pricing- throughout the 2000's prices stayed high for years, it was only once they began a little fall, which was thought to be minor and inconsequential that the selling picked up steam and eventually fell to levels that were a great value. People didn't sell their houses because they thought they were going to continue to gain value. Many instead just had to give their houses to the bank in the end.

Works the same with stocks, most investors do not market time with it since the overvaluation typically happens at end of a long bull market and investors are more fearful of missing a bull move than of buying properly valued stocks.

But there are at least two ways to fix the market valuation problem shown by the PE10... either lower stock prices or raise earnings.... if you raise earnings, and keep the value the same or even growing a bit, your PE10 will come down over the years....


I will have to agree it is not a market timing tool since there is no way it can predict how and when a correction will take place.... so, just because a market is calculated to be 'overvalued' does not mean it will not continue to rise.... remember the 'irrational exuberance' remark was made in 96 and the markets continued to rise for 4 more years....


So, it does not signal a market crash.... but can signal (as I read it) below market returns over the next 20 years.... but since below market returns can still be higher than other investments..... how does it help in making investment decisions....

 

[samclem]

. . .. but can signal (as I read it) below market returns over the next 20 years.... but since below market returns can still be higher than other investments..... how does it help in making investment decisions....

Historically, using PE10 valuation to adjust AA (i.e. moving from stocks to those "other investments" and back) has provided returns that are better, on a risk-adjusted basis, than just sticking with a fixed allocation of stocks and bonds. Call that whatever you want, but it sounds like we have a nomenclature/definition problem, not an effectiveness problem.

PE10 doesn't tell you when the market will turn, but it can apparently indicate that the chances of continuation are changing. That's still useful.

 

[photoguy]

That's one reason I wouldn't use valuation to make a binary "all in" or "all out" decision. But using it to vary between high and low edges of one's equity "comfort window" (e.g. between allocating 40% to equities or 70% to equities) would seem appropriate and a good fit to the imprecise (esp regarding timing) nature of these PE10 indicators.

I agree that seems sensible. Do you follow this approach yourself?

Personally I've been keeping my equity allocation more or less fixed** but if PEs got really high or low, I'd be tempted to shift the percentage. However the last time I feel PEs were extreme (e.g. in 2000), I hadn't started working/investing so I don't know if I would actually go through with a market timing move.

** I've been gradually reducing my equity allocation over the past few years as part of a plan to switch from accumulation to decumulation in ER. I tell myself this isn't market timing, but the increase in PE10 certainly helped reassure me that this was the right move for myself.

Then what good is it

Another use for PE10 would be to set expectations on returns for planning purposes.

 

[Texas Proud]

Another use for PE10 would be to set expectations on returns for planning purposes.

Good point...

 

[Running_Man]

But there are at least two ways to fix the market valuation problem shown by the PE10... either lower stock prices or raise earnings.... if you raise earnings, and keep the value the same or even growing a bit, your PE10 will come down over the years....


I will have to agree it is not a market timing tool since there is no way it can predict how and when a correction will take place.... so, just because a market is calculated to be 'overvalued' does not mean it will not continue to rise.... remember the 'irrational exuberance' remark was made in 96 and the markets continued to rise for 4 more years....


So, it does not signal a market crash.... but can signal (as I read it) below market returns over the next 20 years.... but since below market returns can still be higher than other investments..... how does it help in making investment decisions....

I can only speak for myself, my goal is not to exceed market returns but inflation by 2-3 percent per year. When I feel stocks are too expensive I cut back the percentage that I own for the valuation I feel it is worth, while not totally eliminating that class (25%). It is true that stocks could continue for the next 20 years to over perform other asset classes and not have a major correction to bring the valuation back to either fair value or even undervalued, but I do not fear this, instead I would hope that to be the case as that would mean a continued low inflation environment and solid returns enough to offset inflation in my portfolio for the long term. However, this would be a highly unusual occurrence in stock market history and I think far less likely than a move down by selling pressure to fair value or under in the coming year(s)

 

[big-papa]

Good point...

+1

Though I would really like to see the same type of PE analysis performed on other US indices instead of just the SP500.

 

[sengsational]

Interesting video of Shiller last week. He's not optimistic.

Risk of big stock drops grows: Robert Shiller

CAPE Crusader, LOL!

For people living in retirement, I think this is a dangerous time. --CC"

That's one reason I wouldn't use valuation to make a binary "all in" or "all out" decision. But using it to vary between high and low edges of one's equity "comfort window"

True that! Let's say I can sleep well at night with a 60% equity allocation, but only when the PE10 is X or less. Otherwise, I can't sleep well, so I cut my allocation to 40% equities. As long as you have a definite, non emotional rule that you can follow for reverting to the higher equity allocation.

How about this...When the 25/6% down PE10 triggers, add 20 years to your age and pull the recommended asset allocationallocation for that age. When the 14/6% up rule triggers, go back to the allocation for your real age.

Does changing your asset allocation very occasionally based on a measured parameter (and not on emotion) make one a DMT? I wouldn't think so.

 

[samclem]

Does changing your asset allocation very occasionally based on a measured parameter (and not on emotion) make one a DMT?

I'm afraid most here would throw this into the DMT bin.

I agree that seems sensible. Do you follow this approach yourself?

No, but I think I may. Our AA "window" devoted to equities will stay fairly high (we are comfortable with this due to other aspects of our finances), but I can see using PE10 to toggle between two levels.

 

[FIREd]

That's one reason I wouldn't use valuation to make a binary "all in" or "all out" decision. But using it to vary between high and low edges of one's equity "comfort window" (e.g. between allocating 40% to equities or 70% to equities) would seem appropriate and a good fit to the imprecise (esp regarding timing) nature of these PE10 indicators.

That's what I have been doing for the past 5+ years. My comfort window is 30-70% equities. I vary my equity allocation inside that window based on valuation - PE10 mostly but I do give a little bit of weight to other factors like the current interest rate environment. I recently described my strategy here. I do not use triggers so there are no abrupt allocation changes in my portfolio based on gut feelings. As the market gets more expensive, I gradually decrease my equity allocation towards 30%. As it gets cheaper, I gradually increase it towards 70%.

According to FIREcalc, most of the benefits of owning equities on portfolio longevity is achieved with at least 30% allocated to equities. After that point, the benefits of a higher equity allocation become more marginal, so I figure that as long as I stay in that 30-70% range, I am not taking a lot of longevity risk by experimenting with this strategy.

 

[sengsational]

I recently described my strategy here.

That's a pretty logical approach....I like it. No need to "slam" anything, which might generate regrets. It's not greedy; trying to get the last dime is usually not profitable.

 

[sengsational]

September 1, 2015 Trigger Action, Finally

If you look at the document in the original post, it gives an example of using PE 10 points of 24 and 15, with a trailing percent of 6. The procedure outlined was to check on the first of every month.

Well, we got past 24 back in November of 2013, and it ratcheted up, getting as high as 27 on February 1st 2015. So 94% of that is 25.38. September 1 is the first first of the month that it's below 25.36, so we have a trigger!

This is a very rare event, since there have been only 4 other sell triggers based on that outlined methodology since 1881.

I didn't do it right away, but I finally took action yesterday: changed from and asset allocation designed for a 50 year old, to one designed for an 80 year old.

My plan is to stick with the 80 year old asset allocation unless and until the buy signal comes.

I probably would not have done this if I didn't have somewhere "good" to put the proceeds, but in my ex employer's 401k, there's a guaranteed income fund that's on target to exceed a 3.5% return this year.

I probably would not have done this if I hadn't just been reading Shiller's "Irrational Exuberance" book, where he makes note of quite a few very long periods in history where, after adjusting for inflation, the stock market return did not exceed long treasuries. He basically argues that when the CAPE is high, owners of the market are not being properly compensated for the level of risk that they are taking-on.

I expended a lot of mental energy on this, since it's been drilled into me that stocks are the best/only long-term bet that exceeds inflation. That, and also selling in a downdraft was like finger nails on a chalkboard to me. But that's my plan; shifting my AA based on this DMT methodology that has historically had one in the market about 82% of the time, and only has round-tripped 4 times in 134 years (the next buy signal will complete the 5th round trip).

Here's my spreadsheet. Not the most efficient construction of formulas, but you should be able to watch the trigger mechanism, experiment with values other than 24 and 15, etc.

https://drive.google.com/file/d/0B72EGiKyXAcjbE9tUjh3ek5CcVk/view?usp=sharing

 

[Animorph]

Too slow for me I think, but good luck!

 

[NW-Bound]

Does changing your asset allocation very occasionally based on a measured parameter (and not on emotion) make one a DMT? I wouldn't think so.

Who cares? The same people who call you a DMT will be green with envy or crying sour grapes if the market tanks. It's your money to do as you wish.

 

[Lsbcal]

Who cares? The same people who call you a DMT will be green with envy or crying sour grapes if the market tanks. It's your money to do as you wish.

Right about that. In the end, nobody but us is responsible for our results. If we go with the consensus and it is wrong, we only have the compensation of plenty of company ... and that doesn't pay the bills.

 

[ETFs_Rule]

"Market timing is impossible to perfect." -- Mark Rieppe

 

[NW-Bound]

This is the first time I heard of Mark Rieppe, but borrowing from the platitude I can make this generalization.

"Investing is impossible to perfect" -- NW-Bound

 

[audreyh1]

I didn't do it right away, but I finally took action yesterday: changed from and asset allocation designed for a 50 year old, to one designed for an 80 year old.

My plan is to stick with the 80 year old asset allocation unless and until the buy signal comes.

I probably would not have done this if I didn't have somewhere "good" to put the proceeds, but in my ex employer's 401k, there's a guaranteed income fund that's on target to exceed a 3.5% return this year.

I probably would not have done this if I hadn't just been reading Shiller's "Irrational Exuberance" book, where he makes note of quite a few very long periods in history where, after adjusting for inflation, the stock market return did not exceed long treasuries. He basically argues that when the CAPE is high, owners of the market are not being properly compensated for the level of risk that they are taking-on.

I expended a lot of mental energy on this, since it's been drilled into me that stocks are the best/only long-term bet that exceeds inflation. That, and also selling in a downdraft was like finger nails on a chalkboard to me. But that's my plan; shifting my AA based on this DMT methodology that has historically had one in the market about 82% of the time, and only has round-tripped 4 times in 134 years (the next buy signal will complete the 5th round trip).

Here's my spreadsheet. Not the most efficient construction of formulas, but you should be able to watch the trigger mechanism, experiment with values other than 24 and 15, etc.

https://drive.google.com/file/d/0B72EGiKyXAcjbE9tUjh3ek5CcVk/view?usp=sharing

Is an 80 year old allocation 20% equities, or more?

 

[ETFs_Rule]

"Market timing is impossible to perfect." -- Mark Rieppe

Mark Riepe | About Schwab

 

[sengsational]

Is an 80 year old allocation 20% equities, or more?

The appreciation category goes from about 82% to 58% in the full-on age 50 to 80 change. So some would say this is pretty aggressive to start with. I only did the US stocks right now, so I've got a bit of a hybrid going on. But my change decreased US stock by 40% and increased "U.S. Bonds" (where I'm substituting guaranteed income) a bunch.

 

[audreyh1]

Wow - so you reduced equities to 58%? Well, I guess 20% of that would be "hard assets" - whatever you are using for that. So maybe it's 38% equities.

Yeah - that's more aggressive than me at 53% equities. And I have a higher fixed income than the "80" column too.

 

[sengsational]

Hard assets include real estate, precious metals, and REITs, so you could take at least some of the 20% away from the 58%.

Everything seems to travel in the same direction lately but, these hard assets, not quite lock-step with equities (I hope).

 

[audreyh1]

I count REITs as stocks. They do seem to zig and zag differently than the other equities at least half the time. Precious metals - it really depends on how you invest. A lot of funds/ETFs buy stocks as a proxy. I don't invest in this area, so not clear.

 

[Lsbcal]

Does your house count as your real estate? Last I looked, VG small value had a lot of REITs.

 

[target2019]

Hard assets include real estate, precious metals, and REITs, so you could take at least some of the 20% away from the 58%.

Everything seems to travel in the same direction lately but, these hard assets, not quite lock-step with equities (I hope).

You're shaping up like an endowment manager. David Swensen.
How about alternative investments? I'm using BX as a proxy for that.