Overvalued CAPE10 - does using CAPE8 help?

[NW-Bound]

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]

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/arti...decade-of-muted-returns-despite-strong-growth

 

[audreyh1]

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]

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]

...
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]

.....
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]

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]

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.

 

[HadEnuff]

Is your investment philosophy designed to give you the best chance of maximizing return, or is it designed to give you the best chance to meet your needs so you can live the life you want to live?

With these valuations, if you can't afford a 40% drop in equities, you are over-invested in equities. It doesn't matter if you lose a few % in returns as much as it matters to secure what you need.

 

[DEC-1982]

I think it's pointless to agonize over fine tuning a portfolio, unless one does it for the simple pleasure of it.

 

[HadEnuff]

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.

Sure, but Warren Buffet's wife is in a position to let a 40% "correction" re-correct, while she lives off of the 64% she has left.

The question we should be asking ourselves is can we live on the % we'll have left after a big correction. Younger people especially may not remember that when the market corrected in the late 90s, it didn't rebound as quickly as it did from the '07-'08 tank.

 

[audreyh1]

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.

In structuring your the fixed income part of your portfolio, it's really important to have a chunk of very high quality bonds that will behave well under duress. Not all fixed income are the same.

In 2008:

• Global Bonds +12.00% (JPMorgan Global Government Bond Index (Unhedged), which measures government bond markets around the world)
• Government Bonds +10.81% (Bloomberg Barclays U.S. Intermediate Government Bond Index, which measures the U.S. intermediate- term, investment-grade bond market)
• Cash +1.8% (Citigroup 3-month T-bill Index, which is derived from secondary market Treasury bill rates published by the Federal Reserve Bank)
• Municipal Bonds +1.52% (Bloomberg Barclays 10-year Municipal Bond Index, which measures the long-term municipal bond market)
• Corporate Bonds -2.76% (Bloomberg Barclays U.S. Intermediate Credit Bond Index, which measures the U.S. intermediate-term, investment-grade bond market)
• High Yield Bonds -26.16% (Bloomberg Barclays U.S. High-Yield Corporate Bond Index, which measures the high-yield bond market)

From this PDF (2nd page) which gives a great overview of how different fixed income asset classes have behaved relative to each other and to the S&P500 over the past 20 years.
https://www.mfs.com/wps/FileServerS..._tools/mfsp_20yrsf_fly&servletCommand=default

 

[flyingaway]

Is there some metric similar to CAPE10 for bonds?

 

[BeachOrCity]

Lots of good nuggets in this thread, but what sticks out after reading all the comments is that CAPE and PE ratios are good predictors of portfolio survival and long terms returns only.

As such i think it is ok to
1.. tweak AA WITHIN COMMONLY ACCEPTED BOUNDS for purposed of minimizing downside risk or maximizing upside potential.
2. Decide what swr you think is ok (ie if Low PE/CAPE) then maybe ok to use 4.5 or if PE high maybe better to use 3.0

Overall great thread. thanks Audrey.

By the way, it dawned on me about a month or two ago that i am ridiculously overweight in stocks in my taxable portfolio, so in the middle of a switch to much more bonds AND cash (shorter term). I was about 85 percent stocks. Yes, Yikes, but i am still working though close to RE. Now at about 75 percent.. hate doing this and taking the tax bite in my high earnings years, but the downside risk is too great. Will probably get it to 60 percent stocks by year end. Which, yes i know is still about the max for my age and proximity to RE.

 

[Lsbcal]

Is there some metric similar to CAPE10 for bonds?

As bonds are a competitive investment to stocks, it would be interesting to see a ratio chart of CAPE10 to a suitable bond normalization. Maybe using real rates of the 10 year Treasury for the bond normalization?

I don't have much real return bond data. The Fed 10 year TIPS only goes back to 2003. See: https://fred.stlouisfed.org/series/DFII10

 

[audreyh1]

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.

You are absolutely right. A big factor in the US market averages reaching new highs this year has been the US dollar weakening as other countries improve their economic outlook.

Another reason why international stocks have been on a tear this year.

I was very much feeling the pinch this summer as the US dollar weakened throughout our 6 week Europe trip.

 

[NW-Bound]

True pain was when we made a European trip when a Euro was more than US$1.40, back in 2007 if my memory serves.

But one cannot wait for a better exchange rate to go. One may not be around when that happens, because life is short.

 

[Lsbcal]

You are absolutely right. A big factor in the US market averages reaching new highs this year has been the US dollar weakening as other countries improve their economic outlook.

Another reason why international stocks have been on a tear this year.

I was very much feeling the pinch this summer as the US dollar weakened throughout our 6 week Europe trip.

We currently have 40% of equities in international. So the higher cost for travel was small compared to the equity gains. Now it is true that I will be paying those travel bills for sure but cannot count on banking the currency related investment gains.