Do you adjust your AA based on valuations?

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Do you adjust your Asset Allocation based on valuations?

Yes, written into my IPS
22
20%
Yes, based on what feels right at the time
22
20%
No, don't believe it increases odds of goal acheivement
40
37%
No, too complicated for me
24
22%
 
Total votes : 108

Do you adjust your AA based on valuations?

Postby Sammy_M » Wed May 08, 2013 10:07 am

Based on discussions here and the writings of folks like Wade Pfau, I have at times considered amending my IPS to call for a downward shift in equities as P/E10 levels exceed normal ranges. With mean P/E10 around 16, the current 24 level seems like a time to start downshifting.

Do you adjust your stock/bond allocation based on P/E10, Tobin's q, or some other valuation metric? Why or why not?
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Re: Do you adjust your AA based on valuations?

Postby Iorek » Wed May 08, 2013 10:11 am

That seems like a form of market timing to me, which I don't do for both philosophical and practical reasons.
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Re: Do you adjust your AA based on valuations?

Postby Sammy_M » Wed May 08, 2013 10:16 am

Yes, I agree making a gradual shift in one's target stock/bond split as stock valuation levels rise is indeed market timing. A great deal of discussion on the subject here: viewtopic.php?t=75585
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Re: Do you adjust your AA based on valuations?

Postby YDNAL » Wed May 08, 2013 10:27 am

Sammy_M wrote:Based on discussions here and the writings of folks like Wade Pfau, I have at times considered amending my IPS to call for a downward shift in equities as P/E10 levels exceed normal ranges. With mean P/E10 around 16, the current 24 level seems like a time to start downshifting.

Do you adjust your stock/bond allocation based on P/E10, Tobin's q, or some other valuation metric? Why or why not?

My IPS says..... Stupid, don't just sit there if P/Es hit 44 like in 1999. :)
Landy | Be yourself, everyone else is already taken -- Oscar Wilde
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Re: Do you adjust your AA based on valuations?

Postby The Wizard » Wed May 08, 2013 10:33 am

I don't presently adjust my AA based on stock valuations, but that's not so bad an idea.
Market-timing, smarket-timing.
Let's say your AA is 50% stocks with a +/-5% band. Then as a stock bubble gets mature and valuations are high, you're going to be right up at 55% stocks, depending on your rebalance algorithm. (I rebalance in 1% increments, so I'd be right up at 54% -55% stocks for the duration of that bull.
So maybe it's a better idea to prune back stock exposure closer to target, 49%-50% stock, in anticipation of the eventual cooling of the market.
Not a bad idea whatsoever...
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Re: Do you adjust your AA based on valuations?

Postby otbricki » Wed May 08, 2013 10:58 am

I don't adjust my target AA based on valuation, however I do other things based on value. For example periodic contributions are targeted to asset classes that are under valued in my estimation. Rebalancing bands might also see some 'elasticity changes' due to valuation concerns.
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Re: Do you adjust your AA based on valuations?

Postby CyberBob » Wed May 08, 2013 11:36 am

I've always liked Benjamin Graham's general advice:
Benjamin Graham wrote:Finally, the investor should always have a minimum percentage of his total portfolio in common stocks and a minimum percentage in bond equivalents. I recommend at least 25 per cent of the total at all times in each category. A good case can be made for a consistent 50-50 division here, with adjustments for changes in the market level. This means the investor would switch some of his stocks into bonds on significant rises of the market level, and vice-versa when the market declines. I would suggest, in general, an average seven- or eight-year maturity for his bond holdings.

I also like how he compared valuations not to an asset class and its historical number, but one asset class to the alternative (i.e. stocks to bonds). And right now one would be bumping up against his 75/25 limit, with only 25% in bonds due to their low yield.

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Re: Do you adjust your AA based on valuations?

Postby james22 » Wed May 08, 2013 11:52 am

Yes, I do.
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Jack Bogle on "Market Timing."

Postby Taylor Larimore » Wed May 08, 2013 12:03 pm

Bogleheads:

Adjusting our asset allocation based on stock valuations is a form of market timing aka tactical asset-allocation. This is what Mr. Bogle, our mentor, wrote in Common Sense on Mutual Funds:
The idea that a bell rings to signal when investors should get into or out of the stock market is simply not credible. After nearly fifty years in this business, I do not know of anybody who done it successfully and consistently. I don't even know anybody who knows anybody who has done it successfully and consistently.

There is an option for bold and self-confident investors. It does not abandon the "stay the course" principle, but it allows for a mid course correction if stormy weather threatens on the horizon. If rational forecasts indicate that one asset class offers a considerably better investment opportunity than another, you might shift a modest percentage of your assets from the class judged less attractive to the class judged more attractive. This policy is referred to as tactical asset allocation. It is an opportunistic, transitory, aggressive policy that--if skill, insight, and luck are with you -- may result in marginally better long-term returns than either a fixed-ratio approach or benign neglect.

It is grand to possess skill and insight, athough all of us tend to overate our abilities in both areas. But luck, too, plays a role. Many investors are right but at the wrong time. It does not good to be too early or too late. Tactical asset allocation, if the strategy is used at all, should therefore be used only at the margin. That is, if your optimal strategic allocation is 65 percent stocks, limit any change to no more that 15 percentage points (50 to 80 percent stocks, and implement the change gradually.

The prospect of having the skill, insight, and luck to eliminate your stock position overnight and restore it "when the time is right" is, in my view, patently absurd. Cautious tactical allocation may have a lure for the bold. Full-blown tactical allocation lures only the fool."


Thank you, Mr. Bogle.

Best wishes.
Taylor
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Re: Do you adjust your AA based on valuations?

Postby HongKonger » Wed May 08, 2013 12:05 pm

otbricki wrote:I don't adjust my target AA based on valuation, however I do other things based on value. For example periodic contributions are targeted to asset classes that are under valued in my estimation. Rebalancing bands might also see some 'elasticity changes' due to valuation concerns.


That.
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Re: Do you adjust your AA based on valuations?

Postby allsop » Wed May 08, 2013 12:09 pm

^I have as well and more than one long time BH poster did so during the depth of the financial crisis.

For me as a Swedish based investor the Krona was really hammered, or so I thought, and new investments was in Swedish equity funds along with paying down all debts.

Now the Swedish stock "overweight" is gone and I made a profit. However, it was a bet on the Krona not being valued correctly, and this time I _guessed_ correctly.
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Re: Do you adjust your AA based on valuations?

Postby diasurfer » Wed May 08, 2013 12:23 pm

There were plenty of "respected" observers who said in the months and years after the 2009 lows that with the SP500 at 1100 (1200, 1300, 1400, 1500, 1600, ...) the market had rebounded too much based on any number of factors. I read a lot of plausible arguments for why this should be, including P/E (if calculated "correctly" ... there's the rub). It's market timing and not advised for someone who doesn't want to spend a lot of time reading tea leaves and hoping you picked/guessed right. Over and over again.

Yes, I speak from experience. I missed out on potential gains based on some of these arguments, and wasted a lot of time, before settling on a static equities to fixed income split.

The hardest part was figuring out what that split should be. It would have been nice to know it when I started, but I found that I had to experience the full array of market conditions before I knew what I could be comfortable with in good times and bad.
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Re: Do you adjust your AA based on valuations?

Postby grap0013 » Wed May 08, 2013 12:27 pm

Sammy_M wrote:Based on discussions here and the writings of folks like Wade Pfau, I have at times considered amending my IPS to call for a downward shift in equities as P/E10 levels exceed normal ranges. With mean P/E10 around 16, the current 24 level seems like a time to start downshifting.

Do you adjust your stock/bond allocation based on P/E10, Tobin's q, or some other valuation metric? Why or why not?



What's the alternative to US stocks? If we had a P/E 10 for bonds it'd be thru the stratosphere as they are very overvalued comparing current yield to historical yield . How much do you have in international? Bump that up a little and sell from US equities if you are inclined to do something.
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Re: Do you adjust your AA based on valuations?

Postby greg24 » Wed May 08, 2013 12:28 pm

otbricki wrote:I don't adjust my target AA based on valuation, however I do other things based on value. For example periodic contributions are targeted to asset classes that are under valued in my estimation. Rebalancing bands might also see some 'elasticity changes' due to valuation concerns.


This sounds similar to me, in that I allow myself to market time my rebalancing. I rebalanced recently from stocks to bonds, and I didn't transfer the full amount necessary to keep my age in bonds.
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Re: Do you adjust your AA based on valuations?

Postby inbox788 » Wed May 08, 2013 1:10 pm

Sammy_M wrote:Based on discussions here and the writings of folks like Wade Pfau, I have at times considered amending my IPS to call for a downward shift in equities as P/E10 levels exceed normal ranges. With mean P/E10 around 16, the current 24 level seems like a time to start downshifting.

Do you adjust your stock/bond allocation based on P/E10, Tobin's q, or some other valuation metric? Why or why not?

No, but probably should. It's more complicated than just equities. Rather than just looking at the pe, or better its inverse, the earning yield, and compare it to the dividend yield and the bond yield. So even though increasing pe means decreasing earnings yield, dividend yield is increasing, and bond yields continue to be low. High bond yields would alter the picture keeping pe the same.

beginnersinvest.about.com/od/bondbasic1/a/bond_yields.htm

What and when to make use of this information is what active funds are doing all the time without clear advantages, so putting that into a passive strategy is unknown.
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Re: Do you adjust your AA based on valuations?

Postby Leif » Wed May 08, 2013 3:33 pm

I voted

Yes, based on what feels right at the time

I know it sounds a lot like market timing. However, I think it was Bill Bernstein that said (paraphrasing) if the market is up consider taking a bit more off the table when doing re-balancing. Of course this is sort of built-in to re-balancing bands. However, I guess he meant a bit more than re-balance may call for. So this is what I do. However, its not extreme, perhaps a couple of additional percentage points of the portfolio value.
Investors should diversify across many asset-classes so that whatever happens, we will not have all our investments in underperforming asset classes and thereby fail to meet our goals-Taylor Larimore
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Re: Do you adjust your AA based on valuations?

Postby Sammy_M » Wed May 08, 2013 5:06 pm

inbox788 wrote:It's more complicated than just equities. Rather than just looking at the pe, or better its inverse, the earning yield, and compare it to the dividend yield and the bond yield. So even though increasing pe means decreasing earnings yield, dividend yield is increasing, and bond yields continue to be low. High bond yields would alter the picture keeping pe the same.

I agree with this. After I read the discussion thread that I linked to above and the referenced literature, I sketched out something similar to what the OP was considering. The blue vertical represents real bond yields and the blue horizontal stock earning yields (inverse of P/E10). The intersect (present status shown in yellow) is the target equity allocation. The concept makes good sense to me, but perhaps folks smarter than myself can tell me why it is not.

Image

What and when to make use of this information is what active funds are doing all the time without clear advantages, so putting that into a passive strategy is unknown.

I am skeptical that active funds have the discipline to go against the trend. A couple of years of the trend continuing will result in major fund outflows.
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Re: Do you adjust your AA based on valuations?

Postby ruralavalon » Wed May 08, 2013 5:32 pm

No, for both the reasons listed. Its (a complex type of) market timing, and its too much work/headache/worry for me.
"Everything should be as simple as it is, but not simpler." - Albert Einstein | Wiki article link:Getting Started
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Re: Do you adjust your AA based on valuations?

Postby Artsdoctor » Wed May 08, 2013 6:43 pm

Taylor,

Thank you for both of those quotes. You could have easily just pasted the first one and have been done with it. The second one regarding tactical asset allocation speaks to your fairness.

Bogleheads will (hopefully) always stick to a reasonable asset allocation and then perhaps play within the bands. How much playing you do fuels the conversations here; hopefully, you're also learning in the process. If you want to nibble around the edges, just make sure that you have a benchmark that you're holding yourself accountable to; that usually prevents us from becoming "too big for our britches."

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Re: Do you adjust your AA based on valuations?

Postby MrMatt2532 » Wed May 08, 2013 6:55 pm

From my point of view, valuations are useful in estimating expected returns and likelihood of success.

This, however, does not mean it useful in to increase risk-adjusted returns.
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Re: Do you adjust your AA based on valuations?

Postby Artsdoctor » Wed May 08, 2013 7:10 pm

Matt,

Possibly. There are a couple of caveats.

If you're on the verge on retiring, you might want to take a look at valuations in order to get an idea of risk AND forward-looking returns. Clearly, anyone on the verge on retiring in 1999 would have hopefully noted those lofty valuations (by any reasonable measure) and made adjustments according. That period of entering retirement is a little dicey, I think, because it kind of sets the stage for the next few years.

If valuations are extremely low (again, by any calculation, not subtle changes), you might want to pick up your savings rate right then and there. In 2008, as carnage was all around, I worked a lot more overtime so I could sock more away. I couldn't keep up that pace for long, but I was willing to bust my butt for a few months. I had no way of knowing where the bottom was going to be but I felt I had to shovel more earnings into my portfolio because things looked so desperate.

I don't think that's necessarily market timing. But that's just my opinion here.

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Re: Do you adjust your AA based on valuations?

Postby Clearly_Irrational » Wed May 08, 2013 7:18 pm

My IPS covers this:

PE10 < 10, blue light special light is on, find some extra money and invest it, you may make small AA changes if evidence supports it
PE10 > 10 < 25, green investing light is on, buy and hold, keep your hands off the controls
PE10 > 25 < 30, yellow caution light is on, do research to find out why the market is becoming irrational, you may make small AA changes if evidence supports it
PE10 > 30, red warning light is on, normal rules against active trading are suspended but try not to do anything exceptionally stupid
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Re: Do you adjust your AA based on valuations?

Postby Xanadu » Wed May 08, 2013 7:24 pm

I thought I remembered reading on here that Mr. Bogle himself adjusted his AA back when PE valuations were at a ridiculously high level, no?
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Re: Do you adjust your AA based on valuations?

Postby MrMatt2532 » Wed May 08, 2013 7:29 pm

Artsdoctor wrote:Matt,

Possibly. There are a couple of caveats.

If you're on the verge on retiring, you might want to take a look at valuations in order to get an idea of risk AND forward-looking returns. Clearly, anyone on the verge on retiring in 1999 would have hopefully noted those lofty valuations (by any reasonable measure) and made adjustments according. That period of entering retirement is a little dicey, I think, because it kind of sets the stage for the next few years.

If valuations are extremely low (again, by any calculation, not subtle changes), you might want to pick up your savings rate right then and there. In 2008, as carnage was all around, I worked a lot more overtime so I could sock more away. I couldn't keep up that pace for long, but I was willing to bust my butt for a few months. I had no way of knowing where the bottom was going to be but I felt I had to shovel more earnings into my portfolio because things looked so desperate.

I don't think that's necessarily market timing. But that's just my opinion here.

Artsdoctor

Artsdoctor,

I think we are in agreement. As I mentioned, I think valuations are useful in estimating forward looking returns and likelihood of success. If you did this prior to retirement and didn't feel as though your likelihood of success was great enough, I agree the correct approach would be to save more or work longer.

My point was that even though valuations have an effect on expected returns, it doesn't necessarily mean you can increase your risk-adjusted returns going forward using that information.
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Re: Do you adjust your AA based on valuations?

Postby Iorek » Thu May 09, 2013 10:50 pm

Interestingly, I got something from T Rowe in the mail today where they explain that, contrary to what most investors might think, when they say they have a target allocation in lifecycle funds, they reserve the right to vary from that allocation by 5% in either direction (so for example, although they say they will have 39% in large cap stocks, they really they have 44% in that sector).

According to the fund manager "We are not timing the market, but we are searching for overvalued and undervalued sectors and then positioning portfolios to best capitalize on potential opportunities in the coming 12 to 18 months" and they expect up 25% of long term performance to be related to these deviations from the announced allocations.

Personally I think that is BS. First, I don't see how trying to find "undervalued" sectors to capitalize on in the next 12-18 months is not market timing. Second, I think if you tell people you will be 39% in large cap stocks then you should do your best to be 39% in large cap stocks, especially as you believe that not meeting those allocations could result in a 25% differential in long term performance.

And don't get me started on the other TRP fund manager interviewed who says "I think the Fed's policy [of keeping rates so low] is somewhere between reckless and not having much impact." Well, that's worth 100 basis points.
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Re: Do you adjust your AA based on valuations?

Postby letsgobobby » Fri May 10, 2013 2:34 am

Absolutely and I have since I started investing in the 1990s. With pe10 24 I am in the do nothing camp, ie, age in bonds. If pe10 hits 25 I need to drop my stock allocation by 5%. In 1999 I was 0% stocks, in 2007 25% stocks, in 2008 35-50% stocks, in 2009 70% stocks, now 60% stocks.
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Re: Do you adjust your AA based on valuations?

Postby goalie » Fri May 10, 2013 5:24 am

Hey Bobby,

I made a post similar to yours and it was demanded that I post proof. Getting chided is why the other boards are inferior. Put on a helmet.... :oops:

Chip
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Re: Do you adjust your AA based on valuations?

Postby John3754 » Fri May 10, 2013 7:37 am

Forgive me I'm an unsophisticated investor...equities are "overvalued" and bonds are in a "bubble", so where's my money supposed to go at present?
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Re: Do you adjust your AA based on valuations?

Postby staythecourse » Fri May 10, 2013 10:03 am

I will never understand why folks use valuations. Vanguard itself did a paper that looked at a whole bunch of valuations as a forward predictor and the best of the lot was the heralded PE10 which gave a correlation of 0.41. That means using PE10 would have only predicted the direction of the market 41% of the time. Basically, you could have just flipped a coin and had better odds of being correct, i.e. 50%. That is TERRIBLE!!

They also had a graph over time of what PE10 used data should have predicted and what actually happened and it was hit and miss on if it prevented getting caught up in the extreme ups and down periods, i.e. left and right tail risk. So, it isn't good for that either.

Mr. Bogle and many others are correct when they say do not market time. Trust me I wish it wasn't true, but have not seen good data on ANY valuation tool. I think this is another example of the human mind trying to find a pattern even if there isn't one there.

Good luck.
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Re: Jack Bogle on "Market Timing."

Postby aida2003 » Fri May 10, 2013 10:33 am

Taylor Larimore wrote:Bogleheads:

Adjusting our asset allocation based on stock valuations is a form of market timing aka tactical asset-allocation. This is what Mr. Bogle, our mentor, wrote in Common Sense on Mutual Funds:
There is an option for bold and self-confident investors. It does not abandon the "stay the course" principle, but it allows for a mid course correction if stormy weather threatens on the horizon. If rational forecasts indicate that one asset class offers a considerably better investment opportunity than another, you might shift a modest percentage of your assets from the class judged less attractive to the class judged more attractive. This policy is referred to as tactical asset allocation. It is an opportunistic, transitory, aggressive policy that--if skill, insight, and luck are with you -- may result in marginally better long-term returns than either a fixed-ratio approach or benign neglect.

It is grand to possess skill and insight, athough all of us tend to overate our abilities in both areas. But luck, too, plays a role. Many investors are right but at the wrong time. It does not good to be too early or too late. Tactical asset allocation, if the strategy is used at all, should therefore be used only at the margin. That is, if your optimal strategic allocation is 65 percent stocks, limit any change to no more that 15 percentage points (50 to 80 percent stocks, and implement the change gradually.

The prospect of having the skill, insight, and luck to eliminate your stock position overnight and restore it "when the time is right" is, in my view, patently absurd. Cautious tactical allocation may have a lure for the bold. Full-blown tactical allocation lures only the fool."


Thank you, Mr. Bogle.

Best wishes.
Taylor


If I interpret Mr. Bogle correctly, he does imply to rebalance based on the market valuations of one's portfolio because it skews one of the bands: bonds or stocks. Of course, that's one of the methods. Other can be periodically, once a year, every 5 years, whatever.
Now my question is about the following. Mr. Bogle says If rational forecasts indicate that one asset class offers a considerably better investment opportunity than another, you might shift a modest percentage of your assets from the class judged less attractive to the class judged more attractive.
What rational forecasts is he talking about? If to listen to every 'expert' nowadays, we're in an expanding bubble with both fixed income and stocks being overvalued. So, what to do now? I think our 'average' age (40) of my DH and me points to increasing our bond position which is 18% today, but I'm lost how to go about it and doing nothing :oops: . If I steer all future contributions to bonds in his 401k, won't we be buying 'bubble' bonds (only two bond options in his portfolio PIMCO Total Bond PTTRX & Vanguard TIPS fund). Or if I trim equities, I'd be exchanging one 'bubble gum' for another. I guess the hardest part is to ignore all the doom and gloom noise. :annoyed
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Re: Do you adjust your AA based on valuations?

Postby letsgobobby » Fri May 10, 2013 11:33 am

staythecourse wrote:I will never understand why folks use valuations. Vanguard itself did a paper that looked at a whole bunch of valuations as a forward predictor and the best of the lot was the heralded PE10 which gave a correlation of 0.41. That means using PE10 would have only predicted the direction of the market 41% of the time. Basically, you could have just flipped a coin and had better odds of being correct, i.e. 50%. That is TERRIBLE!!

They also had a graph over time of what PE10 used data should have predicted and what actually happened and it was hit and miss on if it prevented getting caught up in the extreme ups and down periods, i.e. left and right tail risk. So, it isn't good for that either.

Mr. Bogle and many others are correct when they say do not market time. Trust me I wish it wasn't true, but have not seen good data on ANY valuation tool. I think this is another example of the human mind trying to find a pattern even if there isn't one there.

Good luck.

do you have a link to the paper?

Here's an earlier Bogleheads thread. I am in the camp of "valuations clearly predict likelihood of future returns, but only at the extremes." There is a broad middle range where PE10 is not helpful. At the extremes, I am a strong proponent.

viewtopic.php?p=746593
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Re: Do you adjust your AA based on valuations?

Postby Clearly_Irrational » Fri May 10, 2013 12:54 pm

John3754 wrote:Forgive me I'm an unsophisticated investor...equities are "overvalued" and bonds are in a "bubble", so where's my money supposed to go at present?


Derivatives of course!
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Re: Do you adjust your AA based on valuations?

Postby Clearly_Irrational » Fri May 10, 2013 12:56 pm

letsgobobby wrote:I am in the camp of "valuations clearly predict likelihood of future returns, but only at the extremes." There is a broad middle range where PE10 is not helpful. At the extremes, I am a strong proponent.


This is my position as well. I use it as an irrationality detector not a traditional valuation measure.
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Re: Do you adjust your AA based on valuations?

Postby William4u » Fri May 10, 2013 6:44 pm

Where do I find good information on PE10, both past and present?
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Re: Do you adjust your AA based on valuations?

Postby Random Musings » Fri May 10, 2013 11:13 pm

William4u wrote:Where do I find good information on PE10, both past and present?


Here is a chart:

Shiller PE10

RM
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Re: Do you adjust your AA based on valuations?

Postby burma7734 » Sat May 11, 2013 12:35 am

staythecourse wrote:I will never understand why folks use valuations. Vanguard itself did a paper that looked at a whole bunch of valuations as a forward predictor and the best of the lot was the heralded PE10 which gave a correlation of 0.41. That means using PE10 would have only predicted the direction of the market 41% of the time. Basically, you could have just flipped a coin and had better odds of being correct, i.e. 50%. That is TERRIBLE!!



Here is the Vanguard paper

While PE10 has a 0.43 R^2 correlation to 10 year real returns, it is incorrect to say that is a "coin flip". A random event like a coin flip would have a 0 correlation (much like many of the other valuation indicators cited in the article).

As the paper notes, nothing has a good correlation to 1 year ahead real returns. That is the danger in using valuation to make short to AA changes.
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Re: Do you adjust your AA based on valuations?

Postby bayview » Sat May 11, 2013 1:10 am

The Wizard wrote:I don't presently adjust my AA based on stock valuations, but that's not so bad an idea.
Market-timing, smarket-timing.
Let's say your AA is 50% stocks with a +/-5% band. Then as a stock bubble gets mature and valuations are high, you're going to be right up at 55% stocks, depending on your rebalance algorithm. (I rebalance in 1% increments, so I'd be right up at 54% -55% stocks for the duration of that bull.
So maybe it's a better idea to prune back stock exposure closer to target, 49%-50% stock, in anticipation of the eventual cooling of the market.
Not a bad idea whatsoever...

So in this instance, are you rebalancing because of valuation, or because you have hit your predetermined 5% band? Which is your trigger?
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Re: Do you adjust your AA based on valuations?

Postby letsgobobby » Sat May 11, 2013 1:24 am

burma7734 wrote:
staythecourse wrote:I will never understand why folks use valuations. Vanguard itself did a paper that looked at a whole bunch of valuations as a forward predictor and the best of the lot was the heralded PE10 which gave a correlation of 0.41. That means using PE10 would have only predicted the direction of the market 41% of the time. Basically, you could have just flipped a coin and had better odds of being correct, i.e. 50%. That is TERRIBLE!!



Here is the Vanguard paper

While PE10 has a 0.43 R^2 correlation to 10 year real returns, it is incorrect to say that is a "coin flip". A random event like a coin flip would have a 0 correlation (much like many of the other valuation indicators cited in the article).

As the paper notes, nothing has a good correlation to 1 year ahead real returns. That is the danger in using valuation to make short to AA changes.

Thank you for the link and the clarification.

The paper concludes essentially what one 'sees' graphically, which is that middle of the curve pe10 values have little predictive value, whereas values at the extremes are more predictive:

"How much are the extreme P/E values in our sample (the tails of the distribution) responsible for the 40% explanatory power that we observe? If just a few extreme situations, such as the high P/Es in the late 1990s, are driving all of the explanatory power we see, then valuations closer to the overall average level should have less ability to anticipate returns.
We test this hypothesis using the P/E10 valuation measure, by successively dropping tail P/E values from the sample and then measuring the R2 for forecasting 10-year returns. We found little change from the R2 results in Figure 2 until more than 25% of
the sample was dropped (the 12.5% tails on either end). Examining just the middle 50% of P/E values results in much lower explanatory power than when using the full sample
(R2 = 0.20)."
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Re: Do you adjust your AA based on valuations?

Postby staythecourse » Sat May 11, 2013 7:52 am

letsgobobby wrote:
burma7734 wrote:
staythecourse wrote:I will never understand why folks use valuations. Vanguard itself did a paper that looked at a whole bunch of valuations as a forward predictor and the best of the lot was the heralded PE10 which gave a correlation of 0.41. That means using PE10 would have only predicted the direction of the market 41% of the time. Basically, you could have just flipped a coin and had better odds of being correct, i.e. 50%. That is TERRIBLE!!



Here is the Vanguard paper

While PE10 has a 0.43 R^2 correlation to 10 year real returns, it is incorrect to say that is a "coin flip". A random event like a coin flip would have a 0 correlation (much like many of the other valuation indicators cited in the article).

As the paper notes, nothing has a good correlation to 1 year ahead real returns. That is the danger in using valuation to make short to AA changes.

Thank you for the link and the clarification.

The paper concludes essentially what one 'sees' graphically, which is that middle of the curve pe10 values have little predictive value, whereas values at the extremes are more predictive:

"How much are the extreme P/E values in our sample (the tails of the distribution) responsible for the 40% explanatory power that we observe? If just a few extreme situations, such as the high P/Es in the late 1990s, are driving all of the explanatory power we see, then valuations closer to the overall average level should have less ability to anticipate returns.
We test this hypothesis using the P/E10 valuation measure, by successively dropping tail P/E values from the sample and then measuring the R2 for forecasting 10-year returns. We found little change from the R2 results in Figure 2 until more than 25% of
the sample was dropped (the 12.5% tails on either end). Examining just the middle 50% of P/E values results in much lower explanatory power than when using the full sample
(R2 = 0.20)."


Thank you for the clarification. I just remember the graph on that paper which showed it hit and sometimes it missed on the extremes.

Good luck.
...we all think we're above average investors just like we all think we're above average dressers... -Jack Bogle
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Re: Do you adjust your AA based on valuations?

Postby allocator » Sat May 11, 2013 10:13 am

I had been 50/50 US/Int. My TSM allocation exceeded its band so I made a couple of planned charitable contributions with fund shares in lieu of cash. In the meantime, I've been nudging up my international allocation (Int Value, EM, and ex-Us Small Cap) up to around 52%, just based on relative valuations. I won't go much more than that (I arrived at 52.5% based on the use of round numbers in my overall allocation - just easier to track). Probably wont make a noticeable difference over the long haul, but its difficult for me to commit new money to my best recent performers.

So much for tracking error regret.
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Re: Do you adjust your AA based on valuations?

Postby backofbeyond » Sun May 12, 2013 5:20 pm

Clearly_Irrational wrote:My IPS covers this:

PE10 < 10, blue light special light is on, find some extra money and invest it, you may make small AA changes if evidence supports it
PE10 > 10 < 25, green investing light is on, buy and hold, keep your hands off the controls
PE10 > 25 < 30, yellow caution light is on, do research to find out why the market is becoming irrational, you may make small AA changes if evidence supports it
PE10 > 30, red warning light is on, normal rules against active trading are suspended but try not to do anything exceptionally stupid



I've very much enjoyed reading this tread. I've been one of those investors that have only dabbled in fixed income/bonds over the years, primarlily investing in stocks and RE. So this was extremely interesting to see how/when other bogleheads adjust their AA. The above matrix from Clearly Irrational seems to me to be spot on. Thank you for sharing. :sharebeer
The question isn't at what age I want to retire, it is at what income. - George Foreman
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Re: Do you adjust your AA based on valuations?

Postby nedsaid » Sun May 12, 2013 6:22 pm

Valuations do matter. If you buy stocks when P/E's are low, your future expected returns will be higher than if you buy in when P/E's are high. It is simple logic.

That being said, markets can go down a lot when P/E's are low and markets can go up a lot when P/E's are high. You can be right but too soon. So I don't advocate market timing but it pays to pay attention to valuations. It is just that your odds are better if you can buy in at low prices. Your odds are worse if you buy in at high prices.

I like what Peter Lynch said about the Cocktail Party Indicator. He would meet other people at cocktail parties and introduce himself as a fund manager. In the early stages of a bull market, no one would care. Later on in the cycle, people would ask him for stock tips. In the late stages of a bull market, people would be giving him stock tips. Not perfect, but it does give you an indication when market euphoria gets to dangerous levels. Like the shoeshine boys on Wall Street with huge profits on paper in the late 1920's. The argument goes something like this: when everyone is optimistic and has bought, at some point the market runs out of buyers to keep prices up and a fall is inevitable.

When you see euphoria in the streets and everyone is wildly enthusiastic, you might think about reducing your stocks. On the other hand, when there is blood on the streets and the end of the world is at hand, you might have a buying opportunity.

So with all the talk of the bond bubble, I would say stick to your asset allocation plan and buy the bonds you need to meet your plan. On the other hand, I sure would not pile into bonds with wads of new money. Your future returns are likely to be muted.

Even if I thought stocks were in a bubble, I would sell only a portion of my stocks as bubbles can go on for a while.

So for me, the answer is yes but don't overdo it. You need a good asset allocation appropriate for your age and situation.
A fool and his money are good for business.
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Re: Do you adjust your AA based on valuations?

Postby lazyday » Mon May 13, 2013 2:29 am

Strategies between “Never” and “Whenever Valuations Change” need not be arbitrary.

Closer to the first, one might be constructed somewhat like this:

(Only) Whenever the expected returns of investment grade (or better) fixed income exceed the expected returns of equity, reduce equity by 7.5% of total portfolio, moving to whichever fixed income assets seem most underpriced to risk. Reverse when equity expected returns again exceed, by at least 1% (100 bps).

Or the rule(s) might use acceptable expected returns.

I’m not smart or knowledgeable enough to properly create & suggest such rules.
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Re: Do you adjust your AA based on valuations?

Postby edge » Mon May 13, 2013 8:06 am

Does the Vanguard paper analyze any auto-correlation or momentum factors? I did not see a discussion of either. What I would be interested in seeing is if the direction of P/E10 is affected by either.
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Re: Do you adjust your AA based on valuations?

Postby Scooter57 » Mon May 13, 2013 11:42 am

The Vanguard paper evaluates crude valuation measures against the whole market. Not so surprisingly this doesn't work that well.

Applying classic valuation techniques against subsets of the market, on the other hand, can be very helpful. It could have kept you out of tech in the late 90s and will keep you from piling in on blue chip dividend stocks now. It isn't a market timing tool, but it does give a good indication of long term growth possibilities. It also helps you distinguish between investments and speculations. The latter can be profitable for a while, but long term, not so much.
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Re: Do you adjust your AA based on valuations?

Postby lazyday » Mon May 13, 2013 2:46 pm

Scooter57 wrote:classic valuation techniques....
will keep you from piling in on blue chip dividend stocks now
[snip]

Are there metrics showing these stocks more expensive than the market?
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Re: Do you adjust your AA based on valuations?

Postby tetractys » Mon May 13, 2013 3:28 pm

If stock valuations become extreme, I might think about extending bond duration. Stock valuations are certainly not extreme now. Now, in my estimation, it's far more reasonable to continue rebalancing a set asset allocation. -- Tet
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Re: Do you adjust your AA based on valuations?

Postby Random Musings » Mon May 13, 2013 3:39 pm

lazyday wrote:
Scooter57 wrote:classic valuation techniques....
will keep you from piling in on blue chip dividend stocks now
[snip]

Are there metrics showing these stocks more expensive than the market?


see this thread:

Larry S. - Another post on dividend strategies

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Re: Do you adjust your AA based on valuations?

Postby zotty » Mon May 13, 2013 4:25 pm

PE10 is about the same as it was in march 2011. That wasn't a great time to tactically shift, or maybe it was. I guess that depends on the future.

It's probably splitting hairs: Permanently changing your AA with the expectation of lower returns and lower risk seems reasonable. After all, we are all a little better off today than March 2011. On the other hand, changing your AA because you think it will increase your returns is probably not going to work out right.

I think there is a difference, but i don't know why. I'm learning not to fight the market. It seldom obeys my wishes.
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Re: Do you adjust your AA based on valuations?

Postby lazyday » Mon May 13, 2013 4:58 pm

Random Musings wrote:see this thread:

Oh

I agree with Larry on most things but not dividends for some retirees who put in the effort, and have a sensible strategy. Have posted elsewhere on this; there are downsides to dividends and I am not promoting.

The comparison in the link does not compare blue chips to the market. Calling SDY blue chips is a stretch. SDY is compared to a value fund--if SDY had the same historical value loading, that might make sense.

I have noticed some dividend stocks becoming expensive. Just haven’t noticed blue chip dividend stocks as a whole having become more expensive than the market, or I suspect, an index of the same value load.
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