Wade Pfau on High CAPE ratios

[kevink]

This is a short, two-part series that ought to be of interest to many of us. He's advocating reducing equity exposure to 25% when stocks are in nosebleed territory - as they are right now.

Part 1 is here: Is a High CAPE Cause for Alarm? Part 1: CAPE's Relationship to Stock Returns

And Part 2: Valuation-Based Asset Allocation

 

[Fermion]

Looks like they could go up another 50% and still not break the record set in 2000.

 

[haha]

This is a short, two-part series that ought to be of interest to many of us. He's advocating reducing equity exposure to 25% when stocks are in nosebleed territory - as they are right now.

Part 1 is here: Is a High CAPE Cause for Alarm? Part 1: CAPE's Relationship to Stock Returns

And Part 2: Valuation-Based Asset Allocation

I love it. It's the long feared vindication of *****.

 

[FIREd]

As I have said before, my neutral asset allocation is 50/50 and but I let it float between 30/70 and 70/30 based on valuation. I have done that since 2009 IIRC and see no reason to do anything different.

 

[kevink]

I somehow missed it earlier, but there's already a great thread on Pfau's piece over on Bogleheads:

 

[brewer12345]

I love it. It's the long feared vindication of *****.

I assume that ***** is frothing over with mean-spirited glee.

 

[Totoro]

Shown this graph before.

CAPE-10 S&P 500 inverted (x-axis) vs. real return next 10 years. Data for late 1929 up to late 2012.

I personally check CAPE & inflation rates. Specifically I look for when yield minus inflation drops below zero. Sign to head for the exits usually.

 

[golfnut]

As I have said before, my neutral asset allocation is 50/50 and but I let it float between 30/70 and 70/30 based on valuation. I have done that since 2009 IIRC and see no reason to do anything different.

Curious how this works - what valuation level triggers you use to both increase or decrease equities?

Thanks

 

[NYEXPAT]

Anybody who can get 4/3 of anything is simply using "smoke and mirrors" in my book.

 

[FIREd]

Curious how this works - what valuation level triggers you use to both increase or decrease equities?

Thanks

There are no levels or triggers, it is a continuous process. I have a formula taking into account a number of factors and it spits out a valuation number. A valuation of 1 means the market is fairly valued so my target equity allocation is neutral at 50%. If the number is >1, say 1.1, then the market is overvalued by 10% (in my humble estimation), and my target equity allocation falls to 50% / 1.1 = ~45%. If the number is <1, say 0.9, then the market is undervalued and my target equity allocation goes up to 50% / 0.9 = ~56%. But I never let my equity allocation get lower than 30% or higher than 70%.

I don't do that every day. Up until recently, I ran my spreadsheet whenever I had new money to invest. Now that we are not adding more to the pot, I will probably run the spreadsheet once or twice a year before rebalancing to the target AA (although tax considerations may now limit how much rebalancing I can do in any one year).

 

[golfnut]

There are no levels or triggers, it is a continuous process. I have a formula taking into account a number of factors and it spits out a valuation number. A valuation of 1 means the market is fairly valued so my target equity allocation is neutral at 50%. If the number is >1, say 1.1, then the market is overvalued by 10% (in my humble estimation), and my target equity allocation falls to 50% / 1.1 = ~45%. If the number is <1, say 0.9, then the market is undervalued and my target equity allocation goes up to 50% / 0.9 = ~56%. But I never let my equity allocation get lower than 30% or higher than 70%.

I don't do that every day. Up until recently, I ran my spreadsheet whenever I had new money to invest. Now that we are not adding more to the pot, I will probably run the spreadsheet once or twice a year before rebalancing to the target AA (although tax considerations may now limit how much rebalancing I can do in any one year).

Thanks, wonder how your performance would have been in 2007 and 2008.

 

[FIREd]

Thanks, wonder how your performance would have been in 2007 and 2008.

I do not have handy the value for all the parameters needed to run my formula for 2007/2008. But if I remember well, PE10 was around 25 back then, so based on that alone (and PE10 is by far the parameter with the largest weighing factor in my formula), my target asset allocation would have been 32% equity. Much better than the 65% I had at the time (I had a fixed 65/35 AA).

 

[NW-Bound]

It makes sense to be cautious when P/E is high, whether the current value or a sliding average over past years like PE10.

But for portfolio allocation, should we not also consider the prospect of alternative investments, such as bonds, precious metals, cash, etc...? Right now, the other asset classes do not look appealing either.

 

[Koolau]

I love it. It's the long feared vindication of *****.

Wonder how many folks here recall *****. Those who do not, please do not ask.

DW is after me to lower our stock percent to below our current roughly 30%. At least she has no particular reason for this except a feeling. Probably good as any reason when it comes to out guessing the markets. YMMV

 

[Bikerdude]

*****. He who must not be named.

 

[growerVon]

It's Voldemort, right?!

 

[Bikerdude]

It's Voldemort, right?!

Close.

 

[brewer12345]

Worse than voldemort.

 

[GTFan]

Shown this graph before.

CAPE-10 S&P 500 inverted (x-axis) vs. real return next 10 years. Data for late 1929 up to late 2012.

I personally check CAPE & inflation rates. Specifically I look for when yield minus inflation drops below zero. Sign to head for the exits usually.

Maybe it's just me but I can't make heads or tails of what you're trying to show with that graph since everything is blue and there is no legend, time horizon etc.

 

[Totoro]

It's a scatter plot, not a time series.

X-axis is CAEP-10 (inverted CAPE-10). So a CAPE-10 of 25 is 4%.

Y-Axis is the subsequent 10-year annual real return of the S&P 500 (as per Shiller's data), excluding dividends. Also in %

Every blue dot is one data point of a given month. So for a given month, what was the 1/(CAPE-10) and what happened in the subsequent 10 years with the S&P 500 (real annual return ex. dividends). All months starting from end 1929 up to 2012 are included.

I hope this clarifies a bit?

If not, let me know. Maybe the graphics format is messed up (it works ok here, but you may use a different browser), I can repost in a different format then.

 

[Lsbcal]

This is a short, two-part series that ought to be of interest to many of us. He's advocating reducing equity exposure to 25% when stocks are in nosebleed territory - as they are right now.

Part 1 is here: Is a High CAPE Cause for Alarm? Part 1: CAPE's Relationship to Stock Returns

And Part 2: Valuation-Based Asset Allocation

If one were going by this strategy, it looks like they would have been at only 25% equity through most of the market since about 2011. From the start of 2011 the S&P500 is up about 86%.

 

[Texas Proud]

It's a scatter plot, not a time series.

X-axis is CAEP-10 (inverted CAPE-10). So a CAPE-10 of 25 is 4%.

Y-Axis is the subsequent 10-year annual real return of the S&P 500 (as per Shiller's data), excluding dividends. Also in %

Every blue dot is one data point of a given month. So for a given month, what was the 1/(CAPE-10) and what happened in the subsequent 10 years with the S&P 500 (real annual return ex. dividends). All months starting from end 1929 up to 2012 are included.

I hope this clarifies a bit?

If not, let me know. Maybe the graphics format is messed up (it works ok here, but you may use a different browser), I can repost in a different format then.

Ok... now makes sense to me.....


The question I have is there one that would show different time periods....

IOW, I bet that all those data points between 2% and 4% CAPE are during the same time period...

You can kinda see some trend lines in that data that also appear to be other time periods...

It would be interesting to see if the data is still negative sloping if there were one or two time periods taken out... IOW, does it hold all the time or are there a couple of periods that really make a difference to the trend....

 

[Live And Learn]

My head hurts !!!!

 

[Texas Proud]

This is a short, two-part series that ought to be of interest to many of us. He's advocating reducing equity exposure to 25% when stocks are in nosebleed territory - as they are right now.

Part 1 is here: Is a High CAPE Cause for Alarm? Part 1: CAPE's Relationship to Stock Returns

And Part 2: Valuation-Based Asset Allocation

OK... not as good as I was thinking....

The relationship is far from exact as there is still a lot of randomness to be found in the numbers, but statistical analysis suggests that PE10 can explain about 31% of the fluctuations in real stock returns over ten-year periods.

​

That leaves a lot of explaining to do....

 

[Totoro]

The question I have is there one that would show different time periods....

IOW, I bet that all those data points between 2% and 4% CAPE are during the same time period...

You can kinda see some trend lines in that data that also appear to be other time periods...

Same graph with starting time periods grouped by decade and time period (latest start is around 2002 - so you get returns up to 2012). I realize it doesn't look pretty (hey, this is a hobby!), hope it does make sense.

Red is 20s, 30s and 40s.
Green is 50s, 60s and 70s.
Blue is 80s, 90s and early 00s.

Individual shapes gives distinction between individual decades.

I made a typo in my earlier clarification: y-axis is real return including dividends (as per the title), but without re-investing said dividends.

[Edit] Please let me know if you see something unexpected -- no garantuees that I did the analysis fully correct ..