G-Money wrote:There seems to be a somewhat vocal contingent on this forum that appears to look at PE10 as an indicator in isolation. I seem to recall several threads that focused a great deal on the fact that PE10 was >25, with many folks completely ignoring the relatively low yields (and, thus, high valuation) of alternatives such as bonds. I believe at least some of these folks simply planned to sit on the sidelines in cash, but perhaps not.
It does seem like some people treat PE10 > 25 as a bubble indicator. Shiller himself uses this kind of language, so it should not be surprising that others view it this way. People then worry that they should get out, before the bubble bursts. But bernston's point about Graham is that PE is more of an indicator of future potential returns and one has to consider that relative to bond yields. You're not just getting out of equities, you're getting into something else. Getting out of equities, to avoid a possible crash (which is always possible), only to go into bonds (or worse cash) that guarantee a real loss (at the moment) doesn't make a lot of sense. As Swedroe likes to say, a strategy is only good before the fact, not in hindsight. We're always hedging out bets. Thinking in terms of future potential returns and making choices based on one's need and ability to take risk makes sense. Looking for magical bubble indicators does not.
terrabiped wrote: berntson wrote:
Benjamin Graham wrote:Our basic recommendation is that the stock portfolio, when acquired, should have an overall earnings/price ratio—the reverse of the P/E ratio—at least as high as the current high-grade bond rate. This would mean a P/E ratio no higher than 13.3 against an AA bond yield of 7.5%.
The words "when acquired" stood out for me. I can easily see the rationale for acquiring stocks when the price is low. But should one go so far as to sell stocks one has held for a long time because the market has becomes significantly overvalued? I'm thinking of the S&P 500 around 1999, or Japan's stock market around 1990. Stay the course even in those circumstances, or reduce your exposure? I don't know. I'm asking.
I think, as if often the case when speaking of Japan in 1990 (especially) or in this case also the S&P in 1999, this is a problem of not having a globally diversified portfolio masquerading as a concern about valuations and bubbles. If one is not expecting to ride out crashes and recoveries, then one should not be invested in equities at all. If one fears a Japan scenario, one probably has way too much domestic bias in their portfolio. (And if one fears a global equity market Japan scenario, then I think one has unfounded or misplaced fears, because twenty years of global economic deflation means we're all screwed, regardless of how our money is invested.)
LittleD wrote:We've had these discussions in several threads and over several years and I have no quibble with those who just stay the course and rebalance once a year. Some of us who use PE/10 to mitigate risk in our stock portfolio would rather sacrifice return when stocks are expensive and live to fight another day. My IPS mandates that at PE10 over 25, I start to move my allocation of 50/50 stocks-bonds to 40/50/10 stocks-bonds-cash. I do this because stocks are more risky than they were at PE/10 of 20. At PE/10 of 30, I would start to move my allocation to 30/50/20. I have no idea if stocks will go down tomorrow, next month or next year. I know that risk is rising and my IPS tries to fight risk. ... At my age, I care more about controlling risk than making a few extra bucks. For those who still have decades to invest and are in taxable accounts, I would just follow the Boglehead creed and stay the course following their IPS and sleeping soundly at nite.
I guess I wonder if you are mitigating risk or only sacrificing potential return.
To wit, I think this strategy really depends on how one views risk and what one thinks the PE10 means. The PE10 > 25 (or at any number above the historical mean) tells us that the expected returns for the equity market are lower than their historical average. But that does not necessarily mean that risk is higher, except the risk of less returns. But moving from securities (equities) just because of historically lower potential returns, to securities (bonds) with guaranteed even lower returns doesn't make a lot of sense.
On the other hand, if one thinks the PE10, as I note above, is a bubble indicator and the risk is a risk of a crash, then there might be some logic to this strategy. But I suppose that depends on whether or not one believes in a random walk theory of equity prices or a mean reversion theory. Where the "risk" of equities means a risk of a crash, then if one subscribes to random walk the "risk" is not greater when PE10 is 25 or 15 or whatever. But if one subscribes to mean reversion then one could believe the risk of a crash is greater at PE25.
On the other hand, as I say above, if one is not prepared to ride out a crash and recovery then one shouldn't be invested in equities at all. One should only invest as much in equities as they can stand to ride out (which of course depends on one's timeline, as well as other personal variables). So I suspect someone who has a strategy of moving their asset allocation around based on PE10 really is just taking on more equity risk than they can stomach and perhaps would be just as well off lowering their equity allocation permanently.
I also wonder, if one did simulations on historical data with buy and hold on a 50/50 asset allocation, versus an allocation based on 50/50 but shifted around depending on PE10 being above or below 25, if over any period of time the latter strategy does better or has less risk (in terms of standard of deviation). I'm skeptical. Because of course, switching around one's asset allocation runs the risk of missing out of equity returns as much as losses. Doesn't buy and hold tell us that all strategies based on shifting around asset allocations relative to market indicators do no better than random and lose out due to costs? If a PE10 over 25 strategy really delivered better risk adjusted returns in a predicatble manner than simply buy and hold with an approrpiately selected fixed income allocation, wouldn't someone already be running a fund like that?