CAPE-based asset allocation strategy?

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siriusblack
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CAPE-based asset allocation strategy?

Post by siriusblack » Thu May 09, 2019 11:16 am

Bogleheads,
I've been gravitating in my personal investing towards a CAPE-based asset allocation strategy. I'm wondering if anyone here is doing something similar, and/or if anyone here is aware of any good tools/methods for back-testing a CAPE-based asset allocation strategy?

(I've seen the Shiller PE asset allocation back-test at portfolio visualizer-- however, I don't like the #'s they used, and I don't see a good way to customize the rules/values: https://www.portfoliovisualizer.com/tes ... 0&total1=0.)

Here is my basic approach:
1. My "ideal" asset allocation in a market where prevailing valuations are close to the midpoint of the fair-value CAPE range would be 65% stocks / 35% bonds. (My age minus 5 in bonds.)
2. Above the midpoint of fair value CAPE, I would want to reduce stock allocation, but not go beyond 50 / 50.
3. Below the midpoint of fair value CAPE, I would want to increase stock allocation, but not go beyond 80 / 20.
4. Right now, I would use Vanguard's suggested fair-value CAPE range of 23-28.
5. So ... maybe something like the following. CAPE < 20: 80/20. CAPE 20-22: 75/25. CAPE 23-24: 70/30. CAPE 24-25: 65/55. CAPE 26-27: 60/40. CAPE 28-30: 55/45. CAPE > 30: 50/50.

Regarding what values of CAPE to use, I've been convinced from conversations with others on the forum that a "fair value CAPE" range is a better approach than a more simplistic CAPE. In particular, the fair value range is influenced by prevailing interest rates, and prevailing stock buyback patterns which can distort comparisons across different periods of time. In the extreme case, a fair value for CAPE in 1980 should be expected to be very different than a fair value for CAPE in 2019, because (a) interest rates were much higher then, and (b) stock buy-backs were much lower. I would like to factor these elements into my strategy.

Objective is to achieve returns consistent with 65/35 balanced portfolio, but higher sharpe ratio / lower risk. I'd like the backtesting to help me understand whether the strategy has historically achieved this. Ideally, the backtest would also adjust the fair-value CAPE range based on CPI. (Would love to also include buybacks but that sounds difficult.)

Your thoughts and/or experiences with this strategy or anything similar?

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Tyler Aspect
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Re: CAPE-based asset allocation strategy?

Post by Tyler Aspect » Thu May 09, 2019 5:17 pm

Valuation based adjustment to asset allocation is a possibility, but it could be a form of market timing as well. I would limit the adjustment to a simple plus / minus 10%. You know the economy does not work in a certain way just because you think it should.
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Re: CAPE-based asset allocation strategy?

Post by Thesaints » Thu May 09, 2019 5:37 pm

Your strategy already contains plenty of subjective elements. I'm not sure what the point would be in calculating your AA in an "exact" fashion.
Backtesting any particular scheme linking AA to fair-value CAPE won't add many real information. Surely you'll find at least one CAPE-AA (within your acceptable ranges) correspondence law that was more profitable in the past, but that does not mean at all that it will more profitable in the future.

You have an intuition: if FV-CAPE is too high you want to be lighter on stocks, and viceversa, and that's perfectly fine. Instead, finding some mathematical law telling you how much less (or more) stocks to have compared to 65/35 is a desperate endeavor.

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Re: CAPE-based asset allocation strategy?

Post by asif408 » Thu May 09, 2019 11:57 pm

IMO, your method is way too complicated, and you are focusing on the wrong things. My suggestion would be to vary your asset allocation among stock asset classes based on CAPE, not necessarily between stocks and bonds based on CAPE. The evidence supporting the former is stronger than the latter. Also, I wouldn't use one CAPE measurement, I would use an average of several estimates, as that smooths out any outliers.

So, for instance, right now almost every expert that calculates a CAPE ratio has the US at the high end of CAPE relative to its own history and relative to most of the countries in EAFE or MSCI EM, which is reminiscent of the early 2000s.

There could be a case for varying stock bond asset allocation based on CAPE, but evidence for that is weaker, and I would only do that if CAPE ratios for all investable countries were high, like in 2007-2008. Right now, other than the US, the CAPE ratio in most other investable countries is anywhere from reasonable to downright cheap in relative and absolute terms. This won't necessarily protect you from losses in the next year or two, but over the next decade or two it is likely to benefit your overall returns and lower your chance of an extended period of poor performance.

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Re: CAPE-based asset allocation strategy?

Post by heyyou » Fri May 10, 2019 2:51 am

I liked how McClung used quartiles to show relative valuations among vastly different valuation measures (domestic and foreign). No precision remained, but the consensus was apparent.

As for your desire for "similar performance but with lower risk," the market seems to repeat both lessons about investors finding previously unseen risks, and their returns eventually being commensurate with the risks taken. There are managers of huge hedge funds looking for what you want, and they have yet to find it. That is why we by-and-hold index investors have chosen to just accept whatever we get. We expect to adapt our retirement spending to our resources, whatever they may be, often scheming about how to save more to invest during our work years, instead of attempting to squeeze more from the stock market.

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Re: CAPE-based asset allocation strategy?

Post by William Million » Fri May 10, 2019 5:00 am

There are lots of ways investors find value. Why put all your eggs in one metric? If CAPE is so great, why is Schiller generally wrong about the market?

If you had followed CAPE over the past decade's bull market, you would have been wrong more often than right.

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Re: CAPE-based asset allocation strategy?

Post by SovereignInvestor » Fri May 10, 2019 7:17 am

William Million wrote:
Fri May 10, 2019 5:00 am
There are lots of ways investors find value. Why put all your eggs in one metric? If CAPE is so great, why is Schiller generally wrong about the market?

If you had followed CAPE over the past decade's bull market, you would have been wrong more often than right.
Because the issues of comparisons being less relevant over time due to buybacks and CPI changes are real. It is biased high currently. I'm glad OP acknowledges this, I've been the leading voice talking about this issue, and even Shiller himself acknowledges an issue with buybacks since he just added a field to his spreadsheet (but it doesn't fix the issue).

The OP mentions making adjustments for these items, but that may improve the bias issue, but it also adds another layer of error because now we have not just error of model, but error of the adjustment.

And if the decision is stocks versus bonds, CAPE needs to be compared with rates, and OP fortunately notes this, but any ranges need to be constantly adjusted based on interest rates. Ranges appropriate now are not so in say 1982 when 10Y yield was 15% or so.

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Re: CAPE-based asset allocation strategy?

Post by siriusblack » Fri May 10, 2019 7:19 am

Thesaints wrote:
Thu May 09, 2019 5:37 pm
Your strategy already contains plenty of subjective elements. I'm not sure what the point would be in calculating your AA in an "exact" fashion.
Backtesting any particular scheme linking AA to fair-value CAPE won't add many real information. Surely you'll find at least one CAPE-AA (within your acceptable ranges) correspondence law that was more profitable in the past, but that does not mean at all that it will more profitable in the future.

You have an intuition: if FV-CAPE is too high you want to be lighter on stocks, and viceversa, and that's perfectly fine. Instead, finding some mathematical law telling you how much less (or more) stocks to have compared to 65/35 is a desperate endeavor.
1. Not sure exactly what you mean by subjective, but the goal here would be to formulate a written strategy/plan and stick with it. (i.e. It would be part of my IPS.)
2. I never said I was going to backtest a bunch of different scenarios and then find the "magic" or "exact" formula / mathematical law. That's not the objective of the backtesting. I want to backtest the strategy and be sure it actually does produce the results described (similar returns to 65/35 with higher sharpe and lower maximum drawdowns).

My goal is NOT to achieve perfection here. My goal is much, much simpler. I am a fairly risk averse investor, BUT I feel comfortable owning a higher percentage of equities when valuations are lower compared to historical norms (after adjusting for interest rates). When valuations are much higher than historical norms, I feel a lot less comfortable holding higher percentages in equities.

Many have pointed out in response to my post that the future is completely unpredictable and could be different from the past. I fully recognize this possibility-- i.e. valuations could stay high forever, or could get even higher. That's why I would never reduce my equity exposure beyond 50%. However-- in that scenario, where valuations stay high, I would expect stock market returns to be roughly equal to the earnings yield which is currently about 5% (i.e. in the absence of much further multiple expansion). My bond component is yielding greater than 3%, so my portfolio would grow at 4% overall in that case. I'm willing to trade off 1% in exchange for much lower downside risk in that high-valuation environment.

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siriusblack
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Re: CAPE-based asset allocation strategy?

Post by siriusblack » Fri May 10, 2019 7:24 am

asif408 wrote:
Thu May 09, 2019 11:57 pm
My suggestion would be to vary your asset allocation among stock asset classes based on CAPE, not necessarily between stocks and bonds based on CAPE. The evidence supporting the former is stronger than the latter.
Interesting-- can you share more about this? Are you thinking economic sectors (utilities vs. technology, etc.) or are you thinking small/mid/large, value/growth, etc.? (Can you share a link to the evidence supporting this approach?)

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Re: CAPE-based asset allocation strategy?

Post by siriusblack » Fri May 10, 2019 7:32 am

William Million wrote:
Fri May 10, 2019 5:00 am
There are lots of ways investors find value. Why put all your eggs in one metric? If CAPE is so great, why is Schiller generally wrong about the market?

If you had followed CAPE over the past decade's bull market, you would have been wrong more often than right.
Not sure what you mean by "wrong". In my strategy, the goal is to reduce risk when valuations are high, and increase risk when valuations are low.

If I had followed this strategy over the last 20 years, here's what would have happened:
- I would have gone to a conservative 50/50 allocation in the mid-to-late 90's
- Would have moved towards 60/40 (or so) in the mid-2000's
- 80/20 in 2009
- Gradually moved back to 50/50 between 2009 and today

I'm not sure how this would have been "wrong more often than right"-- it looks pretty good to me, and I would have been happy with those allocations in the time periods referenced above.

Finally, I'm not putting all my eggs in one metric -- specifically, I'm putting basically 30% of my portfolio into the metric. 50% is always in stocks. 20% is always in bonds. The other 30% can change depending on the valuation environment (which I translate to increased or decreased risk tolerance).

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siriusblack
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Re: CAPE-based asset allocation strategy?

Post by siriusblack » Fri May 10, 2019 7:36 am

SovereignInvestor wrote:
Fri May 10, 2019 7:17 am
William Million wrote:
Fri May 10, 2019 5:00 am
There are lots of ways investors find value. Why put all your eggs in one metric? If CAPE is so great, why is Schiller generally wrong about the market?

If you had followed CAPE over the past decade's bull market, you would have been wrong more often than right.
Because the issues of comparisons being less relevant over time due to buybacks and CPI changes are real. It is biased high currently. I'm glad OP acknowledges this, I've been the leading voice talking about this issue, and even Shiller himself acknowledges an issue with buybacks since he just added a field to his spreadsheet (but it doesn't fix the issue).

The OP mentions making adjustments for these items, but that may improve the bias issue, but it also adds another layer of error because now we have not just error of model, but error of the adjustment.

And if the decision is stocks versus bonds, CAPE needs to be compared with rates, and OP fortunately notes this, but any ranges need to be constantly adjusted based on interest rates. Ranges appropriate now are not so in say 1982 when 10Y yield was 15% or so.
Here's what I was thinking I would do, in order to get a decent back-test model. (1) Use CPI to adjust the fair value range, using 1980 and 2018 as the boundary years. (2) Do some analysis on prevailing stock buyback rates, again using 1980 and 2018 as the boundary years. Calculate the effect on CAPE of both metrics, and create a linear adjustment between then and now. Would this be 100% perfect? Probably not-- but it would be better than using a more simplistic CAPE comparison.

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siriusblack
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Re: CAPE-based asset allocation strategy?

Post by siriusblack » Fri May 10, 2019 7:58 am

SovereignInvestor wrote:
Fri May 10, 2019 7:17 am
Because the issues of comparisons being less relevant over time due to buybacks and CPI changes are real.
I just noticed Shiller now publishes an "alternative CAPE" spreadsheet, where he incorporates changes in corporate buyback/dividend policies. This looks interesting, I may use this instead of the normal CAPE (at least for the backtest).

From http://www.econ.yale.edu/~shiller/data.htm
As of September 2018, I now also include an alternative version of CAPE that is somewhat different. As documented in Bunn & Shiller (2014) and Jivraj and Shiller (2017), changes in corporate payout policy (i. e. share repurchases rather than dividends have now become a dominant approach in the United States for cash distribution to shareholders) may affect the level of the CAPE ratio through changing the growth rate of earnings per share. This subsequently may affect the average of the real earnings per share used in the CAPE ratio. A total return CAPE corrects for this bias through reinvesting dividends into the price index and appropriately scaling the earnings per share.

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Re: CAPE-based asset allocation strategy?

Post by SovereignInvestor » Fri May 10, 2019 10:54 am

siriusblack wrote:
Fri May 10, 2019 7:58 am
SovereignInvestor wrote:
Fri May 10, 2019 7:17 am
Because the issues of comparisons being less relevant over time due to buybacks and CPI changes are real.
I just noticed Shiller now publishes an "alternative CAPE" spreadsheet, where he incorporates changes in corporate buyback/dividend policies. This looks interesting, I may use this instead of the normal CAPE (at least for the backtest).

From http://www.econ.yale.edu/~shiller/data.htm
As of September 2018, I now also include an alternative version of CAPE that is somewhat different. As documented in Bunn & Shiller (2014) and Jivraj and Shiller (2017), changes in corporate payout policy (i. e. share repurchases rather than dividends have now become a dominant approach in the United States for cash distribution to shareholders) may affect the level of the CAPE ratio through changing the growth rate of earnings per share. This subsequently may affect the average of the real earnings per share used in the CAPE ratio. A total return CAPE corrects for this bias through reinvesting dividends into the price index and appropriately scaling the earnings per share.
Yes interesting. I remember writing about the issue of CAPE and buybacks 4 years ago and being scoffed at mean while the creator himself admits there's an issue.

I don't think that adjusted figure corrects the issue. All it does it use total return so that if market has been surging lately it adjusts CAPE to those higher returns...sort of like this time it's different or altering your process because market which ruins objectivity.

Ideally you multiple the older earnings for an on-level share count factor but it needs to be buyback only because share counts always changed in the past from buyouts and issuance. Also I think every year after maybe 1990s can have CPI annual factor scaled up by 0.5% to 1%.

The buyback issue has nothing to do with reacting to market returns but just adjusting EPS denominator to be consistent. The CAPE would have to be so heavily adjust ed though.

IMO the best alternative is forward PE ...rule of 20. 20 minus 10Y note is rough forward PE target. It implicitly accounts for interest rate level and has no issue with bad trending or changes in tax rates since forward EPS consensus reflects the future not past. YES, forward EPS tend to be too high and get revised but this is always the case so there is not really an issue comparing across time

The SPX traded in lockstep with this from late 1970s to mid 1990s then went into bubble. Then in early 2000s it hit fair value and went undervalued heavily in 2008-13 as market was depressed as interest rates dropped. Since 2017 it's mostly been fair value but was very low in this past 20% correction in late 2018.

This correctly said stocks were fair value to cheap for most of 1980s-1995. Then had them as very expensive for 1996-2001. They were fair from 2002-2007 and cheap from 2008-13, and fair to cheap for most of 2014 to present.

This didn't have stocks super cheap in 1982 which looks bad but this is a relative stock to bond comparison...it didnt say stocks so cheap then..bevause bonds were too.
Bonds were a great buy in 1982..in fact from 1981-2011 long bonds outperformed stocks.

The problem with CAPE is if it is 5...normally it means stocks are cheap but say 10Y yield was imaginary 100% yield....I'd rather own bonds than stocks with PE of 5.

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Re: CAPE-based asset allocation strategy?

Post by alex_686 » Fri May 10, 2019 11:17 am

William Million wrote:
Fri May 10, 2019 5:00 am
There are lots of ways investors find value. Why put all your eggs in one metric? If CAPE is so great, why is Schiller generally wrong about the market?
I like CAPE. I response that CAPE did a poor job in the past decade, I will point out that CAPE also failed to predict that the New England Patriots would win the Superbowl. CAPE makes no prediction if the market is over/under valued.

To the OP, how are you getting the midpoint of the CAPE? Why do you think this is significant?

I don't know of any theoretical basis for any PE (forward, backwards, CAPE, etc.) model to indicate over/under value. I can also saw that historically PEs don't provided any over/under value. So why?

There are 2 uses for PE models.

The first is to predict what returns will be. CAPE is predicting low returns. CAPE has a pretty strong history considering the simplicity of the model. There are better ones out there but they get complicated fast.

The second is to use PE in conjunction with another variable to figure out of the market is over/under valued. 2 good models are the Fed and Yardeni. You can't use PE against itself because if makes no sense. A clue to this is to compare PE and long term bond rates, and thus linked. Is CAPE currently overvalued? The Fed model suggests no, when you compare CAPE with 10 year Treasuries.

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Re: CAPE-based asset allocation strategy?

Post by alex_686 » Fri May 10, 2019 11:21 am

SovereignInvestor wrote:
Fri May 10, 2019 10:54 am
Yes interesting. I remember writing about the issue of CAPE and buybacks 4 years ago and being scoffed at mean while the creator himself admits there's an issue.

I don't think that adjusted figure corrects the issue. All it does it use total return so that if market has been surging lately it adjusts CAPE to those higher returns...sort of like this time it's different or altering your process because market which ruins objectivity.
Another, and better explanation in my opinion, is changes in accounting. For example, it used to be you had to amortize most intangible assets but now you don't. Free Cash Flows To Equity remains unchanged, but earnings are higher.

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Re: CAPE-based asset allocation strategy?

Post by SovereignInvestor » Fri May 10, 2019 12:05 pm

Can you specify the magnitude of accounting changes?

I keep hitting on Buybacks bevause I believe they overstate CAPE by about 16% post 2005 relative to historical average all else equal. CPI about 3%-5%. And tax reform about 9%, for cumulative overstatement of 30% or so.

What you describe would mean recent earnings are higher so recent CAPE readings would be lower than long term averages all else equal. That is the opposite impact..and I believe the magnitude is tiny.


https://seekingalpha.com/article/408638 ... d-buybacks


Another tiny magnitude item I haven't memotioned is CAPE uses GAAP earnings which assume commercial RE depreciates over time and Reits are 3% of SPX so it likely understates about 3% of SPX true earnings. I don't believe Reits were always in the SPX..they only existed after about 1968, and took off in recent decades.

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Re: CAPE-based asset allocation strategy?

Post by Kayakr » Fri May 10, 2019 12:09 pm

IMO the best alternative is forward PE ...rule of 20. 20 minus 10Y note is rough forward PE target. It implicitly accounts for interest rate level and has no issue with bad trending or changes in tax rates since forward EPS consensus reflects the future not past.
Do you have links for those charts?

So the problem with CAPE is outstanding shares? earnings should be the same regardless of buybacks, etc. Shares outstanding only seems to be an 8% problem on average over the last decade. https://www.yardeni.com/pub/sharesos.pdf

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Re: CAPE-based asset allocation strategy?

Post by alex_686 » Fri May 10, 2019 1:11 pm

SovereignInvestor wrote:
Fri May 10, 2019 12:05 pm
Can you specify the magnitude of accounting changes?

I keep hitting on Buybacks bevause I believe they overstate CAPE by about 16% post 2005 relative to historical average all else equal. CPI about 3%-5%. And tax reform about 9%, for cumulative overstatement of 30% or so.

What you describe would mean recent earnings are higher so recent CAPE readings would be lower than long term averages all else equal. That is the opposite impact..and I believe the magnitude is tiny.


https://seekingalpha.com/article/408638 ... d-buybacks


Another tiny magnitude item I haven't memotioned is CAPE uses GAAP earnings which assume commercial RE depreciates over time and Reits are 3% of SPX so it likely understates about 3% of SPX true earnings. I don't believe Reits were always in the SPX..they only existed after about 1968, and took off in recent decades.
Most of my stuff is behind paywalls. Can you see this?
https://www.cfapubs.org/doi/abs/10.2469/faj.v72.n3.1

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Re: CAPE-based asset allocation strategy?

Post by HomerJ » Fri May 10, 2019 1:12 pm

siriusblack wrote:
Fri May 10, 2019 7:19 am
When valuations are much higher than historical norms, I feel a lot less comfortable holding higher percentages in equities.
Valuations have been higher than historical norms for 27 years.

Yet returns have been good for the vast majority of those years. I'm not sure why you think CAPE has predictive power.
Many have pointed out in response to my post that the future is completely unpredictable and could be different from the past. I fully recognize this possibility-- i.e. valuations could stay high forever, or could get even higher. That's why I would never reduce my equity exposure beyond 50%.
Your plan does seem much more reasonable since you are making relatively small changes to your allocations.

If it helps you sleep at night, sounds good to me.

I think the risk of a crash is never zero, so I stay at 50% stocks at all times. I wouldn't invest more in stocks just because CAPE (or any other metric) told me the chance of a crash dropped from 10% to 3%... I'd still want to protect myself from that possible 3% crash.

But I'm close to retirement, and I'm in preservation mode, so your goals may be different.
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Re: CAPE-based asset allocation strategy?

Post by HomerJ » Fri May 10, 2019 1:22 pm

alex_686 wrote:
Fri May 10, 2019 11:17 am
The first is to predict what returns will be. CAPE is predicting low returns. CAPE has a pretty strong history considering the simplicity of the model.
CAPE doesn't have a strong history.

You can look the years 1900-1988 and say "Hey look at how well it tracked those years!"... but the model was DERIVED from those years.

Sure it looks like a pattern was discovered, and there's some value to the data from those years.

But the real test to any model is going forward, and CAPE has been terrible since it was discovered.

I mean, you can explain it away. That's fine. There are reasons returns have been high even with high CAPE like accounting changes, and stock buy-backs, Fed actions like QE, etc, etc., etc.

That's fine. High persistent valuations can totally be explained.

But I find it weird that people just say "CAPE has been pretty good at predicting returns", when it hasn't been. Looking at just one variable (CAPE) hasn't been enough. CAPE predictions have failed because other variables came into play.

The economy is way too complicated to make predictions and move hundreds of thousands of dollars around based on one variable.
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Re: CAPE-based asset allocation strategy?

Post by alex_686 » Fri May 10, 2019 1:39 pm

HomerJ wrote:
Fri May 10, 2019 1:22 pm
I mean, you can explain it away. That's fine. There are reasons returns have been high even with high CAPE like accounting changes, and stock buy-backs, etc, etc., etc.
If not CAPE, what would you suggest?

Let us try this from a different set of view.

I can create a model that fits on a 3x5 card that gives me 60% predictive power. So very parsimonious. Good solid model when offering free advice on a forum like this.

Or I can use the basic CAPE model and refine it. Basic thrust of logic is the same, but now adding second order effects. Taxes, accounting changes etc. We now get to 80% - which is darn good considering we are in the social sciences. As we zoom in for greater precision we have to deal with greater detail, and the detail of economics structures do change over time. So now we have to have a multi-page model. Which is not so good for a free forum like this because most of the models and data inputs live behind a pay wall.

Which takes us back to CAPE 10.

Which also takes us back to the OP. I understand what they are trying to do, but it is important to understand what your model can and can't do. And while I like CAPE, it is not in itself a high/low indicator. It can only be high/low in relationship to something else.

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Re: CAPE-based asset allocation strategy?

Post by asif408 » Fri May 10, 2019 1:49 pm

siriusblack wrote:
Fri May 10, 2019 7:24 am
asif408 wrote:
Thu May 09, 2019 11:57 pm
My suggestion would be to vary your asset allocation among stock asset classes based on CAPE, not necessarily between stocks and bonds based on CAPE. The evidence supporting the former is stronger than the latter.
Interesting-- can you share more about this? Are you thinking economic sectors (utilities vs. technology, etc.) or are you thinking small/mid/large, value/growth, etc.? (Can you share a link to the evidence supporting this approach?)
You could try Meb Faber's book Global Asset Allocation, the Bill Bernstein's Rational Expectations, and research on the StarCapital website:
https://www.starcapital.de/en/research/ ... _markets_1

Most of them reference work by Dimson, Marsh, and Staunton, who produce the Credit Suisse global investment yearbook, which periodically details some of their findings.

I personally use it at a high level, primarily varying allocations among US, developed ex-US, and emerging markets. Using size or sector could work, too, I just haven't seen much research on that so in general, I don't use that as much unless there has been a large divergence in performance. Right now, for example, value has underperformed growth for over a decade worldwide, and sectos such as energy and other commodities have had a decade of near 0 returns. So I'm heavily overweight developed ex-US and EM value stocks, and I have smaller tilts to global energy producers and gold miners. Basically it's a portfolio that has had terrible performance if you look back over the past decade.

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Re: CAPE-based asset allocation strategy?

Post by HomerJ » Fri May 10, 2019 2:08 pm

alex_686 wrote:
Fri May 10, 2019 1:39 pm
HomerJ wrote:
Fri May 10, 2019 1:22 pm
I mean, you can explain it away. That's fine. There are reasons returns have been high even with high CAPE like accounting changes, and stock buy-backs, etc, etc., etc.
If not CAPE, what would you suggest?
I would suggest buy and hold and rebalance and to not try to time the market.
Let us try this from a different set of view.

I can create a model that fits on a 3x5 card that gives me 60% predictive power. So very parsimonious. Good solid model when offering free advice on a forum like this.

Or I can use the basic CAPE model and refine it. Basic thrust of logic is the same, but now adding second order effects. Taxes, accounting changes etc. We now get to 80% - which is darn good considering we are in the social sciences. As we zoom in for greater precision we have to deal with greater detail, and the detail of economics structures do change over time. So now we have to have a multi-page model. Which is not so good for a free forum like this because most of the models and data inputs live behind a pay wall.

Which takes us back to CAPE 10.

Which also takes us back to the OP. I understand what they are trying to do, but it is important to understand what your model can and can't do. And while I like CAPE, it is not in itself a high/low indicator. It can only be high/low in relationship to something else.
This is a much more nuanced answer. Thanks for your response. Your numbers are off a bit I think. CAPE is supposedly only 40% predictive, and that includes ALL the years. It's been much worse recently.
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Re: CAPE-based asset allocation strategy?

Post by Kayakr » Fri May 10, 2019 3:26 pm

There are reasons returns have been high even with high CAPE like accounting changes, and stock buy-backs, etc, etc., etc.
I would think primarily that with the current very low interest rate environment, that all asset prices are bid up to match the same inverse price/yield equation bonds use. Otherwise it would make sense to borrow money and bid them up counting on the rest of the market to do the same. Probably most all will fall when that situation reverses https://www.bloomberg.com/news/articles ... ar-auction

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Re: CAPE-based asset allocation strategy?

Post by SovereignInvestor » Fri May 10, 2019 3:28 pm

Kayakr wrote:
Fri May 10, 2019 12:09 pm
IMO the best alternative is forward PE ...rule of 20. 20 minus 10Y note is rough forward PE target. It implicitly accounts for interest rate level and has no issue with bad trending or changes in tax rates since forward EPS consensus reflects the future not past.
Do you have links for those charts?

So the problem with CAPE is outstanding shares? earnings should be the same regardless of buybacks, etc. Shares outstanding only seems to be an 8% problem on average over the last decade. https://www.yardeni.com/pub/sharesos.pdf
It's not the change in shares outstanding over a decade...it is the change over a decade RELATIVE to the change over another decade.

The difference between 2005-2015 is much larger of a decline than other decades and it's due to buybacks.

Gross shares didn't decline as much as buybacks indicate bevause normal issuacne when SPX companies buy companies and their earnings which are not in SPX before. That always happened and is in history. But buybacks which more than negated normal issuance is only in recent years.

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Re: CAPE-based asset allocation strategy?

Post by SovereignInvestor » Fri May 10, 2019 3:29 pm

Most decades before buybacks we would see share counts ris a bit. Recent decades they fell and the difference between traditional older decades showing a rise and recent ones showing a fall is mostly buybacks.

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Re: CAPE-based asset allocation strategy?

Post by alex_686 » Fri May 10, 2019 3:34 pm

Kayakr wrote:
Fri May 10, 2019 3:26 pm
There are reasons returns have been high even with high CAPE like accounting changes, and stock buy-backs, etc, etc., etc.
I would think primarily that with the current very low interest rate environment, that all asset prices are bid up to match the same inverse price/yield equation bonds use. Otherwise it would make sense to borrow money and bid them up counting on the rest of the market to do the same. Probably most all will fall when that situation reverses https://www.bloomberg.com/news/articles ... ar-auction
Kayakr, to put your post in prospective, you are correct that the current high levels of CAPE are due to low interest rates. So on first order impacts you are spot on. However, as others have noted the power of CAPE is falling. Plus, relative to interest rates, it is currently reading low. So now we move onto second order factors, like changes in accounting standards. Throw those in and CAPE retains its predictive power and is reading correctly.

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Re: CAPE-based asset allocation strategy?

Post by alex_686 » Fri May 10, 2019 4:31 pm

HomerJ wrote:
Fri May 10, 2019 2:08 pm
alex_686 wrote:
Fri May 10, 2019 1:39 pm
If not CAPE, what would you suggest?
I would suggest buy and hold and rebalance and to not try to time the market.
I would suggest that this is a non-answer.

How much should one buy? Why rebalance? This suggests that you have a specific view on your asset allocation, which means you have a specific view on the long term returns of stocks and bonds. How did you come your your views? Here would I suggest CAPE 10 instead of other PE model or historical returns is informative.

To stay on topic, to the OP, and on market timing - yes, market timing is somewhere between very hard to impossible. And if you are going to market time, CAPE 10 is not the way to go. Partly because CAPE 10 does a good job at long term forecasting but not short term forecasting - where I think a good chunk of disagreement between HomerJ and myself is. And partly because CAPE 10 is more of a rough guide than a precision model. But mostly because this is not what this simple model is designed to do. It is designed to give long term estimates of equities returns.

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Re: CAPE-based asset allocation strategy?

Post by HomerJ » Fri May 10, 2019 6:34 pm

alex_686 wrote:
Fri May 10, 2019 4:31 pm
HomerJ wrote:
Fri May 10, 2019 2:08 pm
alex_686 wrote:
Fri May 10, 2019 1:39 pm
If not CAPE, what would you suggest?
I would suggest buy and hold and rebalance and to not try to time the market.
I would suggest that this is a non-answer.

How much should one buy? Why rebalance? This suggests that you have a specific view on your asset allocation, which means you have a specific view on the long term returns of stocks and bonds. How did you come your your views? Here would I suggest CAPE 10 instead of other PE model or historical returns is informative.

To stay on topic, to the OP, and on market timing - yes, market timing is somewhere between very hard to impossible. And if you are going to market time, CAPE 10 is not the way to go. Partly because CAPE 10 does a good job at long term forecasting but not short term forecasting - where I think a good chunk of disagreement between HomerJ and myself is. And partly because CAPE 10 is more of a rough guide than a precision model. But mostly because this is not what this simple model is designed to do. It is designed to give long term estimates of equities returns.
Well we agree about CAPE10.

I don't think my answer was a non-answer though... What's wrong with buy and hold and rebalance? Asset allocation is about risk management, not long-term returns. I probably should be 100% stocks if I was thinking about long-term returns only.
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Re: CAPE-based asset allocation strategy?

Post by Thesaints » Fri May 10, 2019 6:52 pm

siriusblack wrote:
Fri May 10, 2019 7:19 am
1. Not sure exactly what you mean by subjective, but the goal here would be to formulate a written strategy/plan and stick with it. (i.e. It would be part of my IPS.)
65/35 portfolio. Why ?
CAPE < 20: 80/20. CAPE 20-22: 75/25. CAPE 23-24: 70/30. CAPE 24-25: 65/55. CAPE 26-27: 60/40. CAPE 28-30: 55/45. CAPE > 30: 50/50.
Why those numbers ?
That's the subjective part.
2. I never said I was going to backtest a bunch of different scenarios and then find the "magic" or "exact" formula / mathematical law. That's not the objective of the backtesting. I want to backtest the strategy and be sure it actually does produce the results described (similar returns to 65/35 with higher sharpe and lower maximum drawdowns).
Similar, higher and lower by how much ? You start with something very approximate: the 65/35 portfolio and a certain procedure to change allocation as FV-CAPE crosses certain thresholds. What if you backtest and get a return 0.3% higher for your technique compared to constant AA. What does it mean ?
If you found +5% then we may be talking of something worth investigating in depth, but as things aer I'm afraid you will simply measure noise.
My goal is NOT to achieve perfection here. My goal is much, much simpler. I am a fairly risk averse investor, BUT I feel comfortable owning a higher percentage of equities when valuations are lower compared to historical norms (after adjusting for interest rates). When valuations are much higher than historical norms, I feel a lot less comfortable holding higher percentages in equities.
That's very good. So modify your AA when that happens. My suggestion is to fly by the seat of your pants. CAPE too high ? Knock 5% stocks. Continues to be too high ? There goes another 5%. Ultimately, your range is only 80-50 in stocks (btw, 80% is quite unusual for someone fairly risk averse). It only takes 6 steps to go from one extreme to the other at a 5% pace.
Many have pointed out in response to my post that the future is completely unpredictable and could be different from the past. I fully recognize this possibility-- i.e. valuations could stay high forever, or could get even higher. That's why I would never reduce my equity exposure beyond 50%. However-- in that scenario, where valuations stay high, I would expect stock market returns to be roughly equal to the earnings yield which is currently about 5% (i.e. in the absence of much further multiple expansion). My bond component is yielding greater than 3%, so my portfolio would grow at 4% overall in that case. I'm willing to trade off 1% in exchange for much lower downside risk in that high-valuation environment.
Between 65/35 and 50/50 there is but a small difference: if stocks drop 30%, which they certainly can do, in one case you lose 15, in the other you lose 19.5. It makes a 4.5% difference in your initial portfolio which is less than one year of expected returns.
You are thinking too much for such a small move.

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Re: CAPE-based asset allocation strategy?

Post by staythecourse » Fri May 10, 2019 7:25 pm

I think your plan is reasonable. It isn't betting the farm so to speak. I don't think in the end it is going to make much of a diffrence (good or bad) vs. a static asset allocation, but if it helps you "stay the course" go for it. Just STICK WITH IT.

Staying the course of a pretty good plan is more important then having a great plan and not knowing if you can stick with it.

Good luck.
"The stock market [fluctuation], therefore, is noise. A giant distraction from the business of investing.” | -Jack Bogle

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Re: CAPE-based asset allocation strategy?

Post by HanSolo » Fri May 10, 2019 8:22 pm

In a 2015 article, Michael Kitces and Wade Pfau presented the results of an analysis that suggested some advantage in CAPE-based asset allocation:

https://www.aaii.com/journal/article/in ... allocation

Also, there's the tricky question of what constitutes "high" or "low" in CAPE (or any valuation metric, for that matter). In his 2017-Q1 quarterly letter, and in a follow-up, both linked below, Jeremy Grantham suggested that valuations since 1995 or so are a different animal compared with pre-1995, for various reasons. He said that we are likely to revert to the long-term means, but it could take a long time (like decades).

https://www.gmo.com/americas/research-l ... different/

https://www.gmo.com/americas/research-l ... ry-slowly/

Good luck,
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Re: CAPE-based asset allocation strategy?

Post by HomerJ » Fri May 10, 2019 8:44 pm

HanSolo wrote:
Fri May 10, 2019 8:22 pm
In a 2015 article, Michael Kitces and Wade Pfau presented the results of an analysis that suggested some advantage in CAPE-based asset allocation:

https://www.aaii.com/journal/article/in ... allocation
How has that plan worked since 2015? I can't see it since it is behind a paywall.

I went looking for Pfau predictions in 2015, and found a Bogleheads thread talking about that article

viewtopic.php?t=169344

Note that thread is EXACTLY about CAPE-based asset allocation strategy... back in 2015 when valuations were considered to be "sky-high".

Here's a quote from me in 2015 in that thread.
My point is that you guys are repeating the same mistakes every "smart" investor has made... Looking at a back-tested chart and thinking it means something about the future...

Yes getting out of the market way early in 1996 by following CAPE signals didn't cost an investor too much, since bonds returned quite well in that period as well..

So what about now? Investors following CAPE got out in 2013, and have missed a 30% run-up... Is the 2% they are making in bonds making up for that THIS time? Will that chart you showed look the same for the NEXT 20 years?
Yes, there were people who lowered their stock allocation (some all the way to zero) in 2013 (!!!) because they were faithfully following CAPE.

I said they missed out on 30% gains since 2013 back then in 2015... It's nearly 100% gains now. 12% a year since 2013.

At least the OP won't go lower than 50%, so he probably won't be too damaged financially depending on CAPE.
Last edited by HomerJ on Fri May 10, 2019 10:56 pm, edited 1 time in total.
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Re: CAPE-based asset allocation strategy?

Post by SovereignInvestor » Fri May 10, 2019 10:55 pm

HomerJ wrote:
Fri May 10, 2019 8:44 pm
HanSolo wrote:
Fri May 10, 2019 8:22 pm
In a 2015 article, Michael Kitces and Wade Pfau presented the results of an analysis that suggested some advantage in CAPE-based asset allocation:

https://www.aaii.com/journal/article/in ... allocation
How has that plan worked since 2015? I can't see it since it is behind a paywall.

I went looking for Pfau predictions in 2015, and found a Bogleheads thread talking about that article

viewtopic.php?t=169344

Note that thread is EXACTLY about CAPE-based asset allocation strategy... back in 2015 when valuations were considered to be "sky-high".

Here's a quote from me in 2015 in that thread.
My point is that you guys are repeating the same mistakes every "smart" investor has made... Looking at a back-tested chart and thinking it means something about the future...

Yes getting out of the market way early in 1996 by following CAPE signals didn't cost an investor too much, since bonds returned quite well in that period as well..

So what about now? Investors following CAPE got out in 2013, and have missed a 30% run-up... Is the 2% they are making in bonds making up for that THIS time? Will that chart you showed look the same for the NEXT 20 years?
Yes, there were people who lowered their stock allocation (some all the way to zero) in 2013 (!!!) because they were faithfully following CAPE.

I said they missed out on 30% gains since 2013 back then... It's nearly 100% gains now. 12% a year since 2013.

At least the OP won't go lower than 50%, so he probably won't be too damaged financially depending on CAPE.
Going into 2013 CAPE showed over valuation but forward PE was barely 12. Which was one correct?

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Re: CAPE-based asset allocation strategy?

Post by HomerJ » Fri May 10, 2019 10:58 pm

SovereignInvestor wrote:
Fri May 10, 2019 10:55 pm
Going into 2013 CAPE showed over valuation but forward PE was barely 12. Which was one correct?
Looks like forward PE.

But I was 50/50 back then too. Don't get me wrong; I wasn't claiming the market was sure to go up. I was saying that that the people who were SURE the market was going to go down didn't know either.
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Re: CAPE-based asset allocation strategy?

Post by William Million » Sat May 11, 2019 2:25 am

SovereignInvestor wrote:
Fri May 10, 2019 10:55 pm
HomerJ wrote:
Fri May 10, 2019 8:44 pm
HanSolo wrote:
Fri May 10, 2019 8:22 pm
In a 2015 article, Michael Kitces and Wade Pfau presented the results of an analysis that suggested some advantage in CAPE-based asset allocation:

https://www.aaii.com/journal/article/in ... allocation
How has that plan worked since 2015? I can't see it since it is behind a paywall.

I went looking for Pfau predictions in 2015, and found a Bogleheads thread talking about that article

viewtopic.php?t=169344

Yeah, in general, ordinary PE beats CAPE10. Sti!l, I wouldn't rely on PE in isolation.

Note that thread is EXACTLY about CAPE-based asset allocation strategy... back in 2015 when valuations were considered to be "sky-high".

Here's a quote from me in 2015 in that thread.
My point is that you guys are repeating the same mistakes every "smart" investor has made... Looking at a back-tested chart and thinking it means something about the future...

Yes getting out of the market way early in 1996 by following CAPE signals didn't cost an investor too much, since bonds returned quite well in that period as well..

So what about now? Investors following CAPE got out in 2013, and have missed a 30% run-up... Is the 2% they are making in bonds making up for that THIS time? Will that chart you showed look the same for the NEXT 20 years?
Yes, there were people who lowered their stock allocation (some all the way to zero) in 2013 (!!!) because they were faithfully following CAPE.

I said they missed out on 30% gains since 2013 back then... It's nearly 100% gains now. 12% a year since 2013.

At least the OP won't go lower than 50%, so he probably won't be too damaged financially depending on CAPE.
Going into 2013 CAPE showed over valuation but forward PE was barely 12. Which was one correct?

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Re: CAPE-based asset allocation strategy?

Post by William Million » Sat May 11, 2019 2:41 am

William Million wrote:
Sat May 11, 2019 2:25 am
SovereignInvestor wrote:
Fri May 10, 2019 10:55 pm
HomerJ wrote:
Fri May 10, 2019 8:44 pm
HanSolo wrote:
Fri May 10, 2019 8:22 pm
In a 2015 article, Michael Kitces and Wade Pfau presented the results of an analysis that suggested some advantage in CAPE-based asset allocation:

https://www.aaii.com/journal/article/in ... allocation
How has that plan worked since 2015? I can't see it since it is behind a paywall.

I went looking for Pfau predictions in 2015, and found a Bogleheads thread talking about that article

viewtopic.php?t=169344

Yeah, in general, ordinary PE beats CAPE10. Sti!l, I wouldn't rely on PE in isolation.

Note that thread is EXACTLY about CAPE-based asset allocation strategy... back in 2015 when valuations were considered to be "sky-high".

Here's a quote from me in 2015 in that thread.
My point is that you guys are repeating the same mistakes every "smart" investor has made... Looking at a back-tested chart and thinking it means something about the future...

Yes getting out of the market way early in 1996 by following CAPE signals didn't cost an investor too much, since bonds returned quite well in that period as well..

So what about now? Investors following CAPE got out in 2013, and have missed a 30% run-up... Is the 2% they are making in bonds making up for that THIS time? Will that chart you showed look the same for the NEXT 20 years?
Yes, there were people who lowered their stock allocation (some all the way to zero) in 2013 (!!!) because they were faithfully following CAPE.

I said they missed out on 30% gains since 2013 back then... It's nearly 100% gains now. 12% a year since 2013.

At least the OP won't go lower than 50%, so he probably won't be too damaged financially depending on CAPE.
Going into 2013 CAPE showed over valuation but forward PE was barely 12. Which was one correct?
In general, plain vanilla PE is a more accurate valuation metric than CAPE 10. However, I wouldn't recommend using PE in isolation either.

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Re: CAPE-based asset allocation strategy?

Post by SovereignInvestor » Sat May 11, 2019 6:21 am

Not just plain PE but forward PE.

Plain PE of TTM EPS showing expensive market in 2009 and 2017 but both times were great buying opportunities and looking into the past in 2009 saw the recession instead of massive recovery in EPS, and in 2017 it saw slowdown in 2016 not the sharp boom in EPS and highly likely prospect of corporate tax cuts.

The forward PE tells you literally what the market is paying for what it thinks earnings will be. Seems like a pretty good barometer of valuation.

The only issue is cyclicality, in that if one thinks the PE should be say 16 (based on rates), but we are in a recession, then a slightly higher PE should be targeted as earnings may be near bottom cyclically. And if we are in a boom then maybe a lower PE is appropriate because Earnings are near peak. I don't endorse heavily adjusting for cylciality bevause no one knows what will happen, and CAPE tries to promise the ability to normalize for cyclicality but it does so at the expense of ruining everything else by being so backward looking and letting buybacks and CPI adjustments have such a leveraged impact on the calculated CAPE EPS, that if they ever change over time (and yes, buyback level substantially changed from pre 1980 of none to post 2005 of 3%+ per year; and CPI changed), then it distorts comparisons.

Also forward PE or any valuation metric should be viewed compared to interest rates which as Buffett says are the gravity holding down asset prices.

Especially when some are trying to alter AA based on valuation. The valuation needs to be conpared against rates since bonds are the alternative.

If the long term average forward PE is 14, and current PE is 10, but the 10Y yield is 25%, then the PE can say stocks are cheap at 10% earnings yield but treasurys are a much better deal at 25% all day. The PE should be well into single digits if rates are 25%.

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Re: CAPE-based asset allocation strategy?

Post by siriusblack » Sat May 11, 2019 8:44 am

Update:

Did some backtesting yesterday. The CAPE strategy outperforms on total return; however, the effect was small, less than 1% CAGR. I tested various periods between 1985 and 2018, using Shiller's data.

(To simplify the CPI and buy-back effects, I used a fair value CAPE range that increased linearly between 1985 and 2018, with the midpoint starting around 17 and ending up at Vanguard's view of ~25 today. I wanted to have a perfect formula for correcting for those variables, but couldn't figure it out.)

From a risk perspective, the strategy was roughly neutral (which surprised me greatly!). The maximum drawdowns were almost exactly equal. (I didn't calculate sharpe or standard deviation; would take some more work in the spreadsheet.)

Here's what surprised me:

1. CAPE signal caused low allocation to stocks in the late 90's ... but *much* too soon. The bull market kept going for quite a while longer.

2. CAPE signal caused high allocation to stocks in October 2008 ... arguably *much* too soon (where the CAPE dropped from above 20 to about 16 in a short period of time... but then kept falling). This caused the strategy to take losses greater than the simple asset allocation, but then it caught back up and surpassed the simple allocation. It looked like a lot of effort and risk to barely outperform the simple allocation during that period.

After the back-testing, I'm convinced the strategy has *some* merit, but the simple allocation was also strong, and has the benefit of being simpler to execute.

Lesson learned: The CAPE can go a LOT higher and a LOT lower than what I used as the fair value range. Using those levels as triggers can put the portfolio at higher risk too soon in a crash; and reduce risk too early during a bull market. I think if I implement this strategy, I would need to widen the range quite a bit, and perhaps simplify the bands (not much value was added by having a bunch of bands and triggers ... it's really the extremes that made the difference).

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Re: CAPE-based asset allocation strategy?

Post by Bacchus01 » Sat May 11, 2019 9:17 am

SovereignInvestor wrote:
Fri May 10, 2019 12:05 pm
Can you specify the magnitude of accounting changes?

I keep hitting on Buybacks bevause I believe they overstate CAPE by about 16% post 2005 relative to historical average all else equal. CPI about 3%-5%. And tax reform about 9%, for cumulative overstatement of 30% or so.

What you describe would mean recent earnings are higher so recent CAPE readings would be lower than long term averages all else equal. That is the opposite impact..and I believe the magnitude is tiny.


https://seekingalpha.com/article/408638 ... d-buybacks


Another tiny magnitude item I haven't memotioned is CAPE uses GAAP earnings which assume commercial RE depreciates over time and Reits are 3% of SPX so it likely understates about 3% of SPX true earnings. I don't believe Reits were always in the SPX..they only existed after about 1968, and took off in recent decades.
How do you overstate CAPE when it’s a formula derived from historical facts?

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Re: CAPE-based asset allocation strategy?

Post by Glamdring56 » Sat May 11, 2019 10:36 am

I have not found an updated fair value CAPE source on the internet. Where can I find “this weeks” value of the fair market CAPE if I was so inclined?

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Re: CAPE-based asset allocation strategy?

Post by siriusblack » Sat May 11, 2019 12:08 pm

Glamdring56 wrote:
Sat May 11, 2019 10:36 am
I have not found an updated fair value CAPE source on the internet. Where can I find “this weeks” value of the fair market CAPE if I was so inclined?
The only one I've seen is Vanguard's, and I'm not sure how often they publish it. Last I saw it was in the 2019 market outlook report towards the beginning of this year.

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Re: CAPE-based asset allocation strategy?

Post by alex_686 » Sat May 11, 2019 12:27 pm

Bacchus01 wrote:
Sat May 11, 2019 9:17 am
How do you overstate CAPE when it’s a formula derived from historical facts?
Because you want to compare apples to apples. The method - or formula if you will - to calculate earnings has changed over time. So its a formula of formulas. So you need to adjust for the adjustments to calculate earnings.

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Re: CAPE-based asset allocation strategy?

Post by SovereignInvestor » Sat May 11, 2019 2:13 pm

alex_686 wrote:
Sat May 11, 2019 12:27 pm
Bacchus01 wrote:
Sat May 11, 2019 9:17 am
How do you overstate CAPE when it’s a formula derived from historical facts?
Because you want to compare apples to apples. The method - or formula if you will - to calculate earnings has changed over time. So its a formula of formulas. So you need to adjust for the adjustments to calculate earnings.
The issue is CAPE has a bias in recent years. Bias means the actual mean on averagr, is going to be different from what's expected out of the population.

It's like polling NBA plays on their height and getting 6'5"" and assuming thr average America is thst height. Its biased relative to entire population. Post 1990s and especially 2005 CAPE will be greater than they were historical if nothing else changed because of buybacks and CPI.

Statistics 101 says that to draw conclusions about a model especially determining fair value based on relative level of current CAPE to long term mean...we need to make sure the theoretical mean is stable across time.

This is not the case, there is a bias after 2000ish due to buybacks and CPI changes and in the last year due to tax cuts that will make a current CAPE reading greater than if the same earnings power and historical growth for 10 years occurred 50 years ago with the market dynamics, buyback policy and CPI back then.

A statistician should cringe at using CAPE with the huge bias that exists.

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Re: CAPE-based asset allocation strategy?

Post by SovereignInvestor » Sat May 11, 2019 2:16 pm

This bias is why CAPE had been terrible wrong about understating returns for the last 15 years and it will continue to be wrong. Those who say it performed well only can point to data from 30+ years ago which risks having a poor model partially over fit to past data and more importantly data before the bias issue comes into play.

I literally used to recommend CAPE and run regressions in 2011 predicting poor returns and as market kept rising I'd see stocks at pretty decent valuation relative to current earnings and was wondering what I was missing. As I studied predictive modeling and statistics more in school I realized that there were data consistency issues with the CAPE analysis people use.

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Re: CAPE-based asset allocation strategy?

Post by William Million » Sat May 11, 2019 2:37 pm

siriusblack wrote:
Sat May 11, 2019 8:44 am
Update:

Did some backtesting yesterday. The CAPE strategy outperforms on total return; however, the effect was small, less than 1% CAGR. I tested various periods between 1985 and 2018, using Shiller's data.

(To simplify the CPI and buy-back effects, I used a fair value CAPE range that increased linearly between 1985 and 2018, with the midpoint starting around 17 and ending up at Vanguard's view of ~25 today. I wanted to have a perfect formula for correcting for those variables, but couldn't figure it out.)

From a risk perspective, the strategy was roughly neutral (which surprised me greatly!). The maximum drawdowns were almost exactly equal. (I didn't calculate sharpe or standard deviation; would take some more work in the spreadsheet.)

Here's what surprised me:

1. CAPE signal caused low allocation to stocks in the late 90's ... but *much* too soon. The bull market kept going for quite a while longer.

2. CAPE signal caused high allocation to stocks in October 2008 ... arguably *much* too soon (where the CAPE dropped from above 20 to about 16 in a short period of time... but then kept falling). This caused the strategy to take losses greater than the simple asset allocation, but then it caught back up and surpassed the simple allocation. It looked like a lot of effort and risk to barely outperform the simple allocation during that period.

After the back-testing, I'm convinced the strategy has *some* merit, but the simple allocation was also strong, and has the benefit of being simpler to execute.

Lesson learned: The CAPE can go a LOT higher and a LOT lower than what I used as the fair value range. Using those levels as triggers can put the portfolio at higher risk too soon in a crash; and reduce risk too early during a bull market. I think if I implement this strategy, I would need to widen the range quite a bit, and perhaps simplify the bands (not much value was added by having a bunch of bands and triggers ... it's really the extremes that made the difference).
[/you]

amazed that Shiller's scheme CAPE 10 still has following, even as it fails to outperform market year after year. Says more, perhaps, about Shiller's PR talents. If you want to reduce risk, just drop equity allocation by 5 or 10 percent.

Some of these schemes might work over the long haul (perhaps small value tilt with better results than CAPE 10-based strategy), but if they fail in the midterm (5-10 years), most will already abandon - just before the payoff kicks in.

So even if you and Shiller are right about CAPE 10, do you have the stubbornness and perseverance to stick with it through the 1st decade of underperformance?

amazed that Shiller's scheme CAPE 10 still has following, even as it fails to outperform market year after year. Says more, perhaps, about Shiller's PR talents. If you want to reduce risk, just drop equity allocation by 5 or 10 percent.

Some of these schemes might work over the long haul (perhaps small value tilt with better results than CAPE 10-based strategy), but if they fail in the midterm (5-10 years), most will already abandon - just before the payoff kicks in.

So even if you and Shiller are right about CAPE 10, do you have the stubbornness and perseverance to stick with it through the 1st decade of underperformance?

alex_686
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Re: CAPE-based asset allocation strategy?

Post by alex_686 » Sat May 11, 2019 2:37 pm

HanSolo wrote:
Fri May 10, 2019 8:22 pm
In a 2015 article, Michael Kitces and Wade Pfau presented the results of an analysis that suggested some advantage in CAPE-based asset allocation:

https://www.aaii.com/journal/article/in ... allocation
This is a misrepresentation of the article on some key points. The context of the article is that we can use expected market returns - as estimated by CAPE - to generate a better withdrawal strategy in retirement. i.e., if CAPE is low, then expected equities return will be high, so one can have a high withdrawal rate.

I don't think this will help the OP on their strategy.

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William Million
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Re: CAPE-based asset allocation strategy?

Post by William Million » Sat May 11, 2019 2:38 pm

amazed that Shiller's scheme CAPE 10 still has following, even as it fails to outperform market year after year. Says more, perhaps, about Shiller's PR talents. If you want to reduce risk, just drop equity allocation by 5 or 10 percent.

Some of these schemes might work over the long haul (perhaps small value tilt with better results than CAPE 10-based strategy), but if they fail in the midterm (5-10 years), most will already abandon - just before the payoff kicks in.

So even if you and Shiller are right about CAPE 10, do you have the stubbornness and perseverance to stick with it through the 1st decade of underperformance?

alex_686
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Re: CAPE-based asset allocation strategy?

Post by alex_686 » Sat May 11, 2019 2:49 pm

SovereignInvestor wrote:
Sat May 11, 2019 2:13 pm
Statistics 101 says that to draw conclusions about a model especially determining fair value based on relative level of current CAPE to long term mean...we need to make sure the theoretical mean is stable across time.

...

A statistician should cringe at using CAPE with the huge bias that exists.
A couple of points here.

CAPE was not deigned to determine fair value. I don't know of any study that actually advocates using it as a fair value.

Next, let us look at returns. Equity returns are both mean reverting and time varying. That is, for a given period of the market will revert to a mean return. Then a structural or secular event occurs and the mean return changes. You can easily see this a priori but I don't know of anyway to see this a posteriori.

So let me once again say why I like it and make a statistical argument for it. It is intended as a way to estimate expected market returns. For this it works. You are not going to get good results if you use it for something different. Next, statically speaking, it is parsimonious. Often in models and statistics you can improve the accuracy of the model by adding more complexity and variables. However this has costs, for example including false correlations and overfitting. So you want your model to be parsimonious - the fewer the variables the better.

alex_686
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Re: CAPE-based asset allocation strategy?

Post by alex_686 » Sat May 11, 2019 3:22 pm

HomerJ wrote:
Fri May 10, 2019 6:34 pm
I don't think my answer was a non-answer though... What's wrong with buy and hold and rebalance? Asset allocation is about risk management, not long-term returns. I probably should be 100% stocks if I was thinking about long-term returns only.
In general, I might cleave closer to theory than you. Expected Market Returns is one of those variables that you find in almost an equation. Ranging from what one's savings rate should be to what your asset allocation should be. Of course, who knows the future? So estimates must be used.

2 specific items that have been pounded into me from my academic studies. First, you can't divorce risk and return. They are part and parcel - so you just can't lop off risk management in asset allocation without accounting for return. Second, my last post kind of hung of the your use of "rebalance". Every single rebalance strategy that I know of requires you to input expected market returns.

So, back to the OP so we keep this thread on track. You will hear lots of people on this forum say that nobody knows nothing. This is not exactly true, we do know a fair but. HomerJ are kind of bouncing back and forth - I am saying the cup is half full, he is saying the cup is half empty.

I think there is a fair amount you can do with a half full cup - you just have to know that your cup is half full. Specificity on your backtest, most professionals that I know would be glad to pick up 100 bais points. So score. On the flip side, how confident that the 100 extra basis points you are picking up is due to your rules and how much to luck. The general way things go is that a model like this works well in theory but crumbles in the real world. I would guess that the extra 100 basis points comes from luck and coincidence.

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