Overvalued CAPE10 - does using CAPE8 help?

[audreyh1]

I agree - government bonds are better at cushioning through big market drops even though they tend to lag other bond classes during the good times. For this reason I make sure a good chunk of my bond allocation is in high quality bonds. As I increase my bond allocation under high CAPE10 - put it in high quality? Sounds like a good idea.

Good observation that extreme highs in the CAPE10 seem to indicate market selloffs will be more severe. Hadn't thought about that.....

[MichaelB]

From a Consuelo Mack interview with risk expert Peter Bernstein

Quote:

Equities are still valued at historically high prices. Interest rates, I don't have to tell you, are historically low. And so you start from there, and there you are. I think something very important to think about this, that a period of low returns, you think, well, every year maybe we'll have 4%, 5%. It doesn't work that way. Low returns result from high volatility. You have a big year, and then a bad year, and the pattern of low return periods is high volatility, not low volatility. It's a scary time

[Fermion]

What are you supposed to do with that info? We had Shiller predicting a decade of 4% returns (including inflation) and four years into that we are sitting at 40% or higher returns.

[walkinwood]

If you change from 60/40 to 50/50 and say equities fall 50% and treasuries rise 10% (Vanguard intermediate treasury fund returned 13.32% in 2008)

A 60/40 portfolio is has lost 26% of its value and a 50/50 portfolio has lost 20% of its value. That's a pretty big deal! The 60/40 portfolio loses 30% more!

I've been hesitating due to cap gains taxes, but I'm going to think about this some more. I could do half this year and half next.

On the other hand, if the market goes up 40% and treasuries stay flat....
a 60/40 portfolio goes up 24% and a 50/50 portfolio goes up 20%.... ie. that 60/40 goes up 20% more than the 50/50. But since I'm already living comfortably on less than my 4% of portfolio, this doesn't cause a lot of excitement.

[Fermion]

Can treasuries actually rise 10% from these levels? In 2008 bonds were paying significantly more than they are now.

What if the market drops 50% and bonds drop 20%? Has something like that ever happened?

[NW-Bound]

Quote:

Originally Posted by Fermion What are you supposed to do with that info? We had Shiller predicting a decade of 4% returns (including inflation) and four years into that we are sitting at 40% or higher returns.

Is there any warranty that the market will hang on to that 40%?

What I am hoping for is that it will not give it all up (that hurts too much), but instead tread water for the next few years to compensate for the recent gain. That's where my strategy of writing covered calls comes in.

[MichaelB]

Quote:

Originally Posted by Fermion Can treasuries actually rise 10% from these levels? In 2008 bonds were paying significantly more than they are now. What if the market drops 50% and bonds drop 20%? Has something like that ever happened?

In the credit crisis of '08 many high quality bond funds declined along with equities. Such was the fear of insolvency.

I think CAPE10 is more relevant to a discussion of portfolio survival rather than just average future returns.

[NW-Bound]

I found that Bloomberg's article about Vanguard's outlook. It was the viewpoint a Vanguard manager made during an interview a few days ago.

Nathan Zahm of Vanguard Group said that market return will be subdued, that "equity returns will drop to 5 to 8 percent per year, while those for bonds will decline to 2 to 3 percent".

I believe that's in nominal terms, and if we take out the 2% inflation target by the Fed, then bonds will be flat and stocks are up 3 to 6%. Hey, I can live on that. Absolutely no complaint here. Hope it works out like this man thinks.

See: https://www.bloomberg.com/news/artic...-strong-growth

[audreyh1]

Quote:

Originally Posted by Fermion Can treasuries actually rise 10% from these levels? In 2008 bonds were paying significantly more than they are now. What if the market drops 50% and bonds drop 20%? Has something like that ever happened?

Government bonds won't drop 20% if the market drops 50%. They'll go up because there will be a flight to safety.

Corporate bonds can be hit - sometimes hard if there is a credit crunch.

Junk/high-yield bonds are usually clobbered.

[audreyh1]

Quote:

Originally Posted by MichaelB In the credit crisis of '08 many high quality bond funds declined along with equities. Such was the fear of insolvency. I think CAPE10 is more relevant to a discussion of portfolio survival rather than just average future returns.

Government bonds did not decline in 2008. Only the top quality stuff appreciated. Other bonds suffered.

The bond index funds held up pretty well over the period and appreciated even if there was a very brief shallow blip during the worst of the uncertainty.

[Montecfo]

If you change your asset allocation based on valuation, you are a market timer.

I think it is human nature to wish to do so. But look at how ineffective investors are who try to time the market. Look at Dalbar studies. Investors tend to underperform the market massively.

My mantra is: Stay Fully Invested.

[Lsbcal]

Quote:

Originally Posted by audreyh1 ... Personally, I don’t try to determine what the “long term average” of CAPE10 should be, and use that as the gage. I don’t completely believe in the revert to mean philosophy for periods long ago. I tend to look at the last three decades of the curve and compare relative values. Eyeballing it I have picked >=25 as the "overvalued" level and <=18 as the "OK to invest more aggressively", making 21.5 the center of that band. CAPE10 has been above 21 during most of the past three decades. ...

Interesting Audrey that is exactly what I've done, look at the last 3 decades of the PE10 data. Then I rank the current PE10 versus those 30 years. Currently it is at about 85%, i.e. 15% of the months in the last 30 years have had higher PE10.

Here is a plot of this ranking versus a "folded" version of the SP500. This folded version allows one to see the semilog plotted ups and downs of the market. The SP500 (with dividends) is plotted against the right axis and the PE10 ranking in percent is plotted against the left axis.




As many have pointed out in the past, PE10 has poor predictive powers over short periods like the next 1 year. Usually I'm interested in something that is more correlated. But this is one factor I look at along with a more major predictor like the yield curve. FWIW, I'm still at 60/40 and shivering in my boots as the accounts keep growing.

[samclem]

For those interested in using PE10 to adjust their allocations (with all the well understood provisos: you'll be a Dirty Market Timer and you may be "wrong" for a long time), this paper by Dr Wade Pfau written a few years ago may be of particular interest. I liked it.
Highlights:
1) Over thirty year accumulation periods, a PE10-based market timing approach (based on the Dodd-Graham 25-50-75 stock allocation levels)
provided better or equivalent returns than a fixed 50-50 approach in about 90 percent of cases. (see Fig 1).
2) See Table 3 for the investment returns and several measures of volatility for various "max and min" stock allocations (0-100, 10-90, 20-80, 30-70, 40-60) and a straight fixed 50/50 allocation over the period of 1871 through 2010. The market timing strategy required allocation changes on an average of about 5 years, so we're not talking about day trading here. The fixed 50/50 allocation had a max drawdown of 28.96%, none of the market timing portfolios had a dive that deep, and all had higher performance. Even if we stuck with a relatively modest "toggle" between 40% stocks when they are overvalued and 60% when they are undervalued, the PE10-based timing significantly reduced downside volatility and improved results. From 1871 to 2010, $1 would have grown to $13,426 using the fixed 50/50 allocation, and would have grown to $21,567 using the 40-60 switching (even though, over time, the 40-60 strategy was exposed to stocks at an average level of 50.64%, virtually identical to the 50/50 fixed strategy).

[Blue Collar Guy]

I know Wade Pfau does all sorts of analysis, and numbers crunching. Writes papers and teaches at a university.

So whats his personal asset allocation? Is it dynamic? I remember reading Rick Ferri used to publish his personal one.

Ferri had a bunch of slice and dice. Too many for me to mimic. And he then changed funds.

Warren Buffet told his second wife, "when I die" go 90% S&P500 , and 10% bonds.

I looked before for Pfau's positions, couldn't find it.

[GrayHare]

CAPE had better be high during Fed Easy Money else we'd be in serious trouble.

Even Buffett is projecting Dow 1 million 100 years from now, which is only about 3.8% growth per year.

[audreyh1]

I assumed CAPE went high because a lot of the Fed easing went straight to asset inflation. So I'm expecting to see some reversal with their new policy to unwind that easing.

[Sunset]

Quote:

Originally Posted by Blue Collar Guy ..... Warren Buffet told his second wife, "when I die" go 90% S&P500 , and 10% bonds. ....

Yep, that is my plan as well, once I get to 2 Billion, I'm 90% S&P500 , and 10% bonds. Because my withdrawal needed amount per year will be available even if the market drops 95%

[Montecfo]

Quote:

Originally Posted by audreyh1 I assumed CAPE went high because a lot of the Fed easing went straight to asset inflation. So I'm expecting to see some reversal with their new policy to unwind that easing.

No doubt. Fed tightening usually leads to recession. And Fed has been tightening for quite a while now.

[Blue Collar Guy]

Quote:

Originally Posted by Sunset Yep, that is my plan as well, once I get to 2 Billion, I'm 90% S&P500 , and 10% bonds. Because my withdrawal needed amount per year will be available even if the market drops 95%

+1, Hahaha, I was going to add that part, but I wanted to stick to what Wade pfau's AA was.

[Totoro]

One observation regarding 2017: the USD dropped by quite a bit vs. most currencies. That gave a strong return boost for most here, which is partly 'funny money' on the world stage. I had a crazy year a bit before that when the EUR went down the tubes for a while, doesn't mean much.

Another observation: inflation. If it stays around 2% it actually justifies higher P/E multiples. As I wrote in another post recently: Earnings yield is an informative measure too (CAEP10, if you will). It's now around 3%.

With inflation at 1.5% or so you are still looking at 1.5% real returns, excluding any additional growth from reinvested earnings which are typically around 3% per annum. 3% real incidently is at the lower end of most SWR estimates, now you know why: that's the rate at which real earnings have been growing. It's remarkably stable.

So my personal view is that as long governments are able to keep inflation under control (say, below 5%), P/E multiples will never be in the single digits again. A tall order, but signs are that we have become better at it in most developed countries.

If you look at the past several severe drops, they were all happening when inflation went above the real earnings yield.

Whether or not to exclude 2008/09: it gives a bit of a difference, but bear in mind that a lot of the losses posted were an opportunity for companies to completely dump (and overdump) some of their skeletons in the closet. So you'd need to correct the other way as well.

Personally I use the CAPE-10, bond yields and inflation measures as yard sticks. That, coupled with the Graham wisdom: stay within bands. As in, ok to adjust your allocation, just be sure to stay e.g. between 30% and 70%. And have a decent chunk of cash to whether temporary downdrafts.