The CAPEable Portfolio!

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bligh
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The CAPEable Portfolio!

Post by bligh » Thu Jul 13, 2017 7:42 pm

Okay I posted this in another thread but thought it was buried in there and wasn't really related to the orignal question on that thread.


So anyway.. what if you had your Cash or Bond portion be a function of CAPE or some other similar metric. It is market timing, but not in the sense of "I will buy at the market bottom". It is essentially rebalancing on steroids isn't it?

So anyway, what if your plan was to be CAPE ratio * <some factor> in bonds?

So for example.. if the factor was 2. CAPE * 2 would be :

If CAPE is at 10 ... you have 20% in bonds/cash.
If CAPE is at 30 .. you have 60% in bonds/cash.
If CAPE is at 50 .. you have 100% in bonds/cash
If CAPE is at 20 .. you have 40% in bonds/cash.

you get the picture.. You could also make it more interesting by having the factor be age based. progressing from 1 when you are starting out to 2.5 or 3 when you are close to retirement.

Is such a portfolio "market timing" ?

Would such a portfolio actually be less volatile and have higher returns? Is there a way one could backtest such a portfolio? I cannot have been the first one to think of something like this.
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Thesaints
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Re: The CAPEable Portfolio!

Post by Thesaints » Thu Jul 13, 2017 7:46 pm

bligh wrote: Is such a portfolio "market timing" ?
Yes and not even that promising, since it does not take into account interest rates.

alex_686
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Re: The CAPEable Portfolio!

Post by alex_686 » Thu Jul 13, 2017 7:51 pm

bligh wrote:Is such a portfolio "market timing" ?
No, it would not be. That being said I am not sure what the purpose of this strategy would be.
bligh wrote:Would such a portfolio actually be less volatile and have higher returns? Is there a way one could backtest such a portfolio? I cannot have been the first one to think of something like this.
Lower or higher returns relative to what? More volatile than what?

You don't explicit state this but I think you are trying to find a signal to determine if the market is overvalued and going to crash, or undervalued and about to rally. If you are trying to say this then the answer is a firm no. CAPE 10 has no predictive power on this.

If you are trying to predict what the returns will be then the answer is yes, it does have predictive power.

i.e., the current high CAPE 10 gives us no clue if the market is going to go up or down. It does predict that we will have low real returns over the next 10 years.

http://www.cfapubs.org/doi/pdf/10.2469/faj.v72.n3.1

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bligh
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Re: The CAPEable Portfolio!

Post by bligh » Thu Jul 13, 2017 7:53 pm

Thesaints wrote:
bligh wrote: Is such a portfolio "market timing" ?
Yes and not even that promising, since it does not take into account interest rates.
The usual argument against market timing is "you cannot time your entry and exit.. so dont try".. but this approach lays out what the entry and exit points are. If I remember correctly, William Bernstein was somewhat in favor of over rebalancing in a similar way on the recently posted Meb Faber podcast.

How are interest rates relevant to the proportion of bonds you hold in any of the other portfolios like the 3 fund portfolio or the permanent portfolio or such?

Thesaints
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Re: The CAPEable Portfolio!

Post by Thesaints » Thu Jul 13, 2017 7:59 pm

bligh wrote:
Thesaints wrote:
bligh wrote: Is such a portfolio "market timing" ?
Yes and not even that promising, since it does not take into account interest rates.
The usual argument against market timing is "you cannot time your entry and exit.. so dont try".. but this approach lays out what the entry and exit points are. If I remember correctly, William Bernstein was somewhat in favor of over rebalancing in a similar way on the recently posted Meb Faber podcast.
How would that be different from "I buy when prices go above the 200-day EMA and I sell when they go below" ? As long as you base your AA not on who you are, but on who you think the market is, that's "market timing"
How are interest rates relevant to the proportion of bonds you hold in any of the other portfolios like the 3 fund portfolio or the permanent portfolio or such?
Because P/E = 20 may look expensive if bonds yield 6%, but it looks like a steal when they yield 1%.

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bligh
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Re: The CAPEable Portfolio!

Post by bligh » Thu Jul 13, 2017 8:03 pm

alex_686 wrote: Lower or higher returns relative to what? More volatile than what?
Say a traditional 60/40 portfolio that stayed static and just re-balanced over the period.

alex_686 wrote: If you are trying to predict what the returns will be then the answer is yes, it does have predictive power.

i.e., the current high CAPE 10 gives us no clue if the market is going to go up or down. It does predict that we will have low real returns over the next 10 years.
Interesting, I think I see what you are saying. It isn't a signal on whether it is a good time to buy or not, but that I should probably expect lower returns on the money I do have invested in stocks.

kiddoc
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Re: The CAPEable Portfolio!

Post by kiddoc » Thu Jul 13, 2017 8:05 pm

I use something similar but less dramatic. My cash/bond deviation from goal caps out at 15-20%. I am sure if you do a long term analysis where the market eventually recovers, a buy and hold strategy would be much more successful than this. Larry Swedroe analyzed an interesting article from Estrada et al. in this article: Valuation Metrics

The article concludes that the strategy really doesn't boost returns, might add costs and increases the number of transactions. I believe that would be true in almost all scenarios except maybe a black swan event like the infamous Japan example. I chose this strategy for myself as I have never experienced a large bear market. While I believe my risk taking potential is significant, it is still untested and I'd rather be humble, miss out on some gains, and be able to stay the course. This strategy helps me stick to my IPS, regardless of what the market does. Assuming a net portfolio return of 6%, I felt holding a max of 15-20% cash, hence missing out on ~1% of annualized portfolio return for 5-10 years (until my risk tolerance is tested in a bear market) is acceptable. I don't make any excuses: this is market timing.
"The four most dangerous words in investing are: 'this time it's different.'" - Sir John Templeton

aristotelian
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Re: The CAPEable Portfolio!

Post by aristotelian » Thu Jul 13, 2017 8:15 pm

bligh wrote:
Thesaints wrote:
bligh wrote: Is such a portfolio "market timing" ?0
Yes and not even that promising, since it does not take into account interest rates.
The usual argument against market timing is "you cannot time your entry and exit.. so dont try".. but this approach lays out what the entry and exit points are. If I remember correctly, William Bernstein was somewhat in favor of over rebalancing in a similar way on the recently posted Meb Faber podcast.

How are interest rates relevant to the proportion of bonds you hold in any of the other portfolios like the 3 fund portfolio or the permanent portfolio or such?
Part of the reason why stocks are high is that interest rates are historically low. Many believe the Fed has been artificially propping up the stock market. Once interest rates normalize it stands to reason that CAPE will normalize as well. Hopefully it happens gradually.

I listened to that podcast as well and thought about setting up a rebalancing system similar to OP although I am considering doing it just for a portion of my portfolio, like my IRA (which is currently 100% stock and 25% of my portfolio).

I posted to see if there was a CAPE-based ETF that would rebalance between stocks and bonds but apparently such a thing does not exist: viewtopic.php?p=3441467#p3441467
Last edited by aristotelian on Thu Jul 13, 2017 9:37 pm, edited 1 time in total.

alex_686
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Re: The CAPEable Portfolio!

Post by alex_686 » Thu Jul 13, 2017 8:18 pm

bligh wrote:It isn't a signal on whether it is a good time to buy or not, but that I should probably expect lower returns on the money I do have invested in stocks.
Correct. This ties into what Thesaints said:
Thesaints wrote:Because P/E = 20 may look expensive if bonds yield 6%, but it looks like a steal when they yield 1%.
What is the "correct" E/P ratio, which is just the inverse of the P/E ratio. Answer: The Long Term Risk Free Rate + Equity Risk Premium.

Long Term Rates are low, so P/E would be high.

The Equity Risk Premium (ERP), the extra return investors ask for in return for the extra risk of stock, is low, so P/E ratio would be high.

Now, the million dollar question is why the ERP is low. Answer
Market expects low risk and low returns in the future.
The is a surplus of savings, pushing ERP low.
The market is irrational.

You are fishing for the last one, the irrational market. Sorry, CAPE 10 can limit the questions but it can't answer them for you.

asif408
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Re: The CAPEable Portfolio!

Post by asif408 » Thu Jul 13, 2017 9:56 pm

So OP, how do you account for investments outside the US (assuming you are not a US only investor)? Russia has a CAPE of 5 now, Brazil about 10, Turkey 11, Poland 12. US is around 28. Assuming you believe in CAPE, why not load up on those countries?

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bligh
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Re: The CAPEable Portfolio!

Post by bligh » Thu Jul 13, 2017 10:58 pm

asif408 wrote:So OP, how do you account for investments outside the US (assuming you are not a US only investor)? Russia has a CAPE of 5 now, Brazil about 10, Turkey 11, Poland 12. US is around 28. Assuming you believe in CAPE, why not load up on those countries?
If I were to go towards that type of portfolio I would not compare the CAPE of one country against another's due to the differences in political risk, growth rates, currency risks, and many others. I do think you could compare the CAPE of one country against its own history. So, for example, if Russia usually has a CAPE of 20 but now it's plummeted to 5, it would seem that investing in Russian stocks would probably have higher expected returns over an intermediate term time frame in relation to its own long term performance. Either way, I believe I have heard it mentioned recently that emerging market equities were attractively priced at the moment, so it looks like there are many who agree with you. :)

To be clear, my portfolio is (and will remain) the pretty boring 3 fund portfolio - I don't know enough about investing to think I can build something better. :)

I was attempting to satisfy my intellectual curiosity. It seemed like a great idea, when it occurred to me.. it still seems interesting, and I would love to see if anyone has proposed anything similar or a backtest of how such a portfolio would have done compared to a 60/40. .. My guess when I posted it was that it seemed so obvious that someone would either have thought of it already or that it was badly flawed in some way that I didn't understand. Seems like it may be the latter.

alex_686
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Re: The CAPEable Portfolio!

Post by alex_686 » Thu Jul 13, 2017 11:08 pm

bligh wrote: I was attempting to satisfy my intellectual curiosity. It seemed like a great idea, when it occurred to me.. it still seems interesting, and I would love to see if anyone has proposed anything similar or a backtest of how such a portfolio would have done compared to a 60/40. .. My guess when I posted it was that it seemed so obvious that someone would either have thought of it already or that it was badly flawed in some way that I didn't understand. Seems like it may be the latter.
There was the first link that I gave you. Here is another.

Financial Market History: Reflections on the Past for Investors Today", edited by by David Chambers and Elroy Dimson. Chapter 2, A Historical Perspective on Time-Varying Expected Returns by Antti Ilmanen.

In short, not good. Lower returns, higher volatility.

1noahone
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Re: The CAPEable Portfolio!

Post by 1noahone » Fri Jul 14, 2017 3:14 am

There is a way to backtest this... kinda. Check this out https://www.portfoliovisualizer.com/tes ... sisResults

This backtest adjusts allocation by PE in the following way:

PE10 >= 22 - 40% stocks, 60% bonds
14 <= PE10 < 22 - 60% stocks, 40% bonds
PE10 < 14 - 80% stocks, 20% bonds

You can see that it does do a good job of mitigating bad drawdowns and keeping up/surpassing its benchmark since 1985.

lyrictulip
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Re: The CAPEable Portfolio!

Post by lyrictulip » Fri Jul 14, 2017 5:43 am

What you're describing is called "Tactical Asset Allocation." It has a long history of various proponents, in various forms, including perhaps most notably Benjamin Graham. Even Jack Bogle said that he decreased his equity allocation at the height of the tech bubble.

There are dozens of threads on this forum about various permutations of this idea, though everyone seems to call it something different. If you'd like a good overview, Vanguard has a research paper here, https://personal.vanguard.com/pdf/flgtaa.pdf

They conclude,
TAA can add value at the margin, if designed with the appropriate rigor to overcome significant risk factors and obstacles unique to the strategy. Our results show that while some TAA strategies have added value, on average TAA strategies have not produced statistically significant excess returns over all time periods.
I ultimately concluded that I'm probably not smarter than the market and that, to coin a phrase, "God Almighty does not know the proper price-earnings multiple for a common stock." You also have to consider that actually executing a PE based tactical asset allocation might involve holding your equity allocation down for decades, and ask yourself whether or not you have the fortitude to do that.

EDIT: I'll add a link to this timely post by Larry Swedroe discussing this very issue http://www.etf.com/sections/index-inves ... nopaging=1
I hope the lessons you take away are: There are logical reasons for valuations to have drifted up; accounting changes and the fall in the propensity to pay dividends make valuations today appear higher than they would otherwise be relative to the long-term historical data; and because there’s so much variation over time in the equity risk premium, there isn’t any methodology that will produce highly accurate forecasts of stock returns—stocks are risky investments no matter the horizon.
With the caveat- I don't necessarily agree (except with the second half of that quote). You can make arguments for any PE ratio you like being perfectly rational, and there is a flavor of "this time is different" to all this. The bottom line remains, nobody knows nothing. Make your plan and stick to it, but be sure that it's one that you can actually sleep with.
Last edited by lyrictulip on Fri Jul 14, 2017 8:08 am, edited 1 time in total.

selftalk
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Re: The CAPEable Portfolio!

Post by selftalk » Fri Jul 14, 2017 6:38 am

Don`t you think that the large financial institutions who employ the brightest investment people from all over the world and provides them with the best up to date data bases and latest software have tried every conceivable way working day and night to enhance market returns and yet history shows that the S&P 500 beats on average 80% of these financial institutions and everyone else or so long term. Do you honestly think that you could discover a better way ? That isn`t rational thinking in my opinion but I guess hope springs eternal. You may want to read the 2013 Berkshire Hathaway annual report pages 17-20 written by one of the best if not the best investors in the world.

asif408
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Re: The CAPEable Portfolio!

Post by asif408 » Fri Jul 14, 2017 9:33 am

bligh wrote:I was attempting to satisfy my intellectual curiosity. It seemed like a great idea, when it occurred to me.. it still seems interesting, and I would love to see if anyone has proposed anything similar or a backtest of how such a portfolio would have done compared to a 60/40. .. My guess when I posted it was that it seemed so obvious that someone would either have thought of it already or that it was badly flawed in some way that I didn't understand. Seems like it may be the latter.
CAPE is widely known, no doubt about that. The better question is, first, is the strategy implementable in the real world, and if so, how long will it take to show up (if it shows up at all) and will it be arbitraged away at some point? Using CAPE is a strategy that takes many years to play out and has a large behavioral element involved (buying countries where the news is terrible).

I'm sure all the big financial institutions know about it. The better question is, can/will they implement it or are they limited by the structure of their institution? For instance, buying low CAPE stocks as an investment strategy could do poorly for several years. How long do institutions stick with a manager or staff that does poorly for many years?

Swelfie
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Re: The CAPEable Portfolio!

Post by Swelfie » Fri Jul 14, 2017 1:37 pm

I do tactically allocate based on CAPE, but handle it a bit differently, because as others have said, the CAPE can be affected by bond prices. My equity allocation is effectively split between 4 buckets:

Domestic - 50%
Developed - 25%
Emerging - 5%
CAPE - 20%

I split the cape bucket equally among the markets that are currently below their median CAPE. If they are all high I'll just shove them into Domestic TSM to keep my currency risk lower. Right now the low markets are Domestic and Emerging. So right now my AA is:

Domestic - 50%
Developed - 35%
Emerging - 15%

This keeps me fully invested in equities, but puts a bit more tilt towards the markets with a higher expected return.

Does it work? Who knows. I'm happy with it this year. It doesn't seem to hurt, doesn't take me out of the market and doesn't seem too crazy to me. Also, I would never take a capital gains hit in taxable to do this. I only muck around in tax deferred, tax loss harvesting and new investment.

staythecourse
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Re: The CAPEable Portfolio!

Post by staythecourse » Fri Jul 14, 2017 3:58 pm

bligh wrote: To be clear, my portfolio is (and will remain) the pretty boring 3 fund portfolio - I don't know enough about investing to think I can build something better. :)
Looks like you already know as much as any good investor knows. Will there be active strategies BETTER then passive, bogleheads style approach? The answer is a resounding YES. The better question is can you identify the better approach IN ADVANCE? The answer is no. Or even figuring out if the active strategies was due to luck or skill, i.e. reproduceable.

I am not sure why so many folks have such a hard time accepting the inevitable truth that THERE IS NOW WAY OF CREATING A BETTER MOUSETRAP to eek out more returns. The funnier thing is even if there was a method everybody else would use it and the advantage would be lost.

The basics of being a great passive investor is accepting the market is efficient enough so no reason to waste your time trying to out think it. Better to focus on other aspects of investing: Getting a high paying job, LBYM, saving, asset allocation, avoiding active management, being cognizant that fees and taxes eat into long term returns, and staying the course.

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

aristotelian
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Re: The CAPEable Portfolio!

Post by aristotelian » Fri Jul 14, 2017 8:51 pm

staythecourse wrote:
bligh wrote: To be clear, my portfolio is (and will remain) the pretty boring 3 fund portfolio - I don't know enough about investing to think I can build something better. :)
Looks like you already know as much as any good investor knows. Will there be active strategies BETTER then passive, bogleheads style approach? The answer is a resounding YES. The better question is can you identify the better approach IN ADVANCE? The answer is no. Or even figuring out if the active strategies was due to luck or skill, i.e. reproduceable.

I am not sure why so many folks have such a hard time accepting the inevitable truth that THERE IS NOW WAY OF CREATING A BETTER MOUSETRAP to eek out more returns. The funnier thing is even if there was a method everybody else would use it and the advantage would be lost.

The basics of being a great passive investor is accepting the market is efficient enough so no reason to waste your time trying to out think it. Better to focus on other aspects of investing: Getting a high paying job, LBYM, saving, asset allocation, avoiding active management, being cognizant that fees and taxes eat into long term returns, and staying the course.

Good luck.
I think it is rather close minded to dismiss anything other than buy and hold Total Stock Market. Poster above showed that CAPE based timing system backtested produces similar returns with remarkably better stability. I imagine if the system was not so extreme - same bands but ranging from 60/40 to 80/20 instead of 40/60 to 80/20 - I bet the CAPE based system would actually outperform. If you can have the same return with lower risk, I think this is worth considering.

Systematic tactical allocation is a far cry from active management. OP is proposing a clear system with decision rules based on historical data.

Many also "eke out better returns" with factor investing and/or reduce risk by weighting REIT or alternatives. These are logical strategies with both theory and empirical support. There are not many "free lunches" but there may be a few. If there is a way to substantially reduce risk without sacrificing return, I certainly want to consider it rather than simply falling back on Boglehead dogma.

staythecourse
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Re: The CAPEable Portfolio!

Post by staythecourse » Fri Jul 14, 2017 10:23 pm

aristotelian wrote:I bet the CAPE based system would actually outperform. If you can have the same return with lower risk, I think this is worth considering.
Great idea. Now tell me the person who actually has done this on a prospective basis and made money out of it? Then tell me even if there is one how do you know it was skill and not luck. The math supports someone can flip head 20 times in a row. That is not skill it is luck.

Folks using factor investing and lower correlation assets are NOT using "strategies", but the crux of MPT and math to improve risk adjusted returns. Factors are NOT meant as a free lunch. They are higher returns then beta for taking on more risk. Non correlating asset classes are not strategies, but pure math. Look at the math for the equation of portfolio return and you will see how decreased variance improves return. It is math not a strategy.

Where is the math or studies or prospective results to suggest this CAPE idea. No offense to you or the original poster but this idea is about 10 years old or more old. It is not novel. So why isn't it done? No one is interested in making more money? Maybe it doesn't work and that is why? Or do you think you were the first and/ or others have figured out the secret sauce and just hiding it for others. Trust me there are computers running different ideas NOT STOP on Wall Street which have done variations of this and other strategies for the last 20+ years. In which case, how come we haven't heard of the superstar manager using this technique?

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

aristotelian
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Re: The CAPEable Portfolio!

Post by aristotelian » Fri Jul 14, 2017 10:58 pm

staythecourse wrote:
aristotelian wrote:I bet the CAPE based system would actually outperform. If you can have the same return with lower risk, I think this is worth considering.
Great idea. Now tell me the person who actually has done this on a prospective basis and made money out of it? Then tell me even if there is one how do you know it was skill and not luck. The math supports someone can flip head 20 times in a row. That is not skill it is luck.

Folks using factor investing and lower correlation assets are NOT using "strategies", but the crux of MPT and math to improve risk adjusted returns. Factors are NOT meant as a free lunch. They are higher returns then beta for taking on more risk. Non correlating asset classes are not strategies, but pure math. Look at the math for the equation of portfolio return and you will see how decreased variance improves return. It is math not a strategy.

Where is the math or studies or prospective results to suggest this CAPE idea. No offense to you or the original poster but this idea is about 10 years old or more old. It is not novel. So why isn't it done? No one is interested in making more money? Maybe it doesn't work and that is why? Or do you think you were the first and/ or others have figured out the secret sauce and just hiding it for others. Trust me there are computers running different ideas NOT STOP on Wall Street which have done variations of this and other strategies for the last 20+ years. In which case, how come we haven't heard of the superstar manager using this technique?

Good luck.
I would not be looking to make money, I would be looking (primarily) to reduce risk.

I take your points on factor investing and REIT, but then you lose me with your hyperbole about coin flips. A system with a theory and clear decision rules backtested to 1985 is not just "getting lucky".

If this is a 10 year old idea, where is the study that says it does not or cannot work? Seriously, I would like to read that study. Perhaps CAPE is not the only variable and there could be others. I am not sold on it either, but I would not reject it out of hand.

I do not buy into perfect market efficiency. Stocks were overvalued in 2008. Bubbles happen. People are greedy and irrational. You may never know when they will peak, but I can imagine a system to give you some protection against them.

By the way, I was researching this topic myself and came up with this excellent thread with almost 700 posts. My interpretation of the overall thread is that it is an idea to seriously consider and not dismiss out of hand. viewtopic.php?t=75585
Last edited by aristotelian on Sat Jul 15, 2017 7:33 am, edited 1 time in total.

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packer16
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Re: The CAPEable Portfolio!

Post by packer16 » Fri Jul 14, 2017 11:22 pm

The issue with both CAPE and factor strategies is they assume the past will be the same as the future & there has been a large number of times when a strategy based upon the past has not worked because the future is different. This can lead the overconfidence that the strategy will work & make the followers the suckers at the table. Why should someone get more return because of a systematic weighing system of certain factors that is easily reproducible by many others? What you see in the data as observed by John Bogle himself is an oscillation between when growth & value stocks do well & no discernible trend in either direction. If growth vs. value returns is more oscillation than direction, then how can you rely on getting higher expected returns? This where the ERP differs from factors in that although the ERP oscillates it is always directionally positive while factors do not appear to be directional.

Folks also claim that investing with factors reduces risk. I disagree in that whenever an more oscillating than directional factor is added to the mix you are increasing timing risk of when the factor is going to do well. Why should you be rewarded for this risk when it is easily diversifable by buying either the growth or value factor funds? So you need to asses for each type of diversification what the change in expected return will be. There is a point where expected return is reduced to a point where it does not make sense to have these oscillating assets in your portfolio.

The bigger issue with the CAPE timing systems is opportunity cost of holding bonds. Currently, if we use Damodaran's data the ERP is about 5% while the LT bond rate is about 2.3% per year (resulting in a total stock return of 7.3%) for July 2017. So the opportunity cost for holding bonds is 5% per year. So if the market crashes 4 years from now you are still are ahead with stocks until equities decline by 21%. If you wait 10 years, you are ahead if equities decline by more than 61%. This illustrates that any timing system has a huge headwind and why few if any have worked in generating returns higher than 100% stock up to the volatility level you can tolerate.

Packer
Buy cheap and something good might happen

aristotelian
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Re: The CAPEable Portfolio!

Post by aristotelian » Sat Jul 15, 2017 7:58 am

packer16 wrote:The issue with both CAPE and factor strategies is they assume the past will be the same as the future & there has been a large number of times when a strategy based upon the past has not worked because the future is different. This can lead the overconfidence that the strategy will work & make the followers the suckers at the table. Why should someone get more return because of a systematic weighing system of certain factors that is easily reproducible by many others?
To me the point of this system is more about reducing risk than increasing return. You are going to miss some of the market highs but protect yourself against market lows. As you correctly state, the real question is how much return you give up while waiting for the market to crash and CAPE to normalize. I agree, it is possible that high CAPE could be sustainable, particularly with historically low interest rates.

For me, the question I have with buy-and-hold is whether there might be a kind of overconfidence that the next market low will be like previous ones, with a fairly rapid recovery. What if the next recovery takes 20 years, like a Japan scenario? Maybe the true answer is simply a more conservative permanent allocation, but a CAPE based strategy would seem to be a good middle ground that at least gets some periods of full stock exposure while reducing downside risk.

I agree with your point on opportunity cost of holding bonds. That is the tradeoff of this approach.

Personally, I am not considering a massive change in allocation due to CAPE, but shifting a few points in a conservative direction seems prudent, as Bernstein was suggesting on the Meb Faber podcast. I wonder if he could be convinced to get on this thread and elaborate?

staythecourse
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Re: The CAPEable Portfolio!

Post by staythecourse » Sat Jul 15, 2017 8:51 am

aristotelian wrote:
staythecourse wrote:
aristotelian wrote:I bet the CAPE based system would actually outperform. If you can have the same return with lower risk, I think this is worth considering.
Great idea. Now tell me the person who actually has done this on a prospective basis and made money out of it? Then tell me even if there is one how do you know it was skill and not luck. The math supports someone can flip head 20 times in a row. That is not skill it is luck.

Folks using factor investing and lower correlation assets are NOT using "strategies", but the crux of MPT and math to improve risk adjusted returns. Factors are NOT meant as a free lunch. They are higher returns then beta for taking on more risk. Non correlating asset classes are not strategies, but pure math. Look at the math for the equation of portfolio return and you will see how decreased variance improves return. It is math not a strategy.

Where is the math or studies or prospective results to suggest this CAPE idea. No offense to you or the original poster but this idea is about 10 years old or more old. It is not novel. So why isn't it done? No one is interested in making more money? Maybe it doesn't work and that is why? Or do you think you were the first and/ or others have figured out the secret sauce and just hiding it for others. Trust me there are computers running different ideas NOT STOP on Wall Street which have done variations of this and other strategies for the last 20+ years. In which case, how come we haven't heard of the superstar manager using this technique?

Good luck.
I would not be looking to make money, I would be looking (primarily) to reduce risk.

I take your points on factor investing and REIT, but then you lose me with your hyperbole about coin flips. A system with a theory and clear decision rules backtested to 1985 is not just "getting lucky".

If this is a 10 year old idea, where is the study that says it does not or cannot work? Seriously, I would like to read that study. Perhaps CAPE is not the only variable and there could be others. I am not sold on it either, but I would not reject it out of hand.

I do not buy into perfect market efficiency. Stocks were overvalued in 2008. Bubbles happen. People are greedy and irrational. You may never know when they will peak, but I can imagine a system to give you some protection against them.

By the way, I was researching this topic myself and came up with this excellent thread with almost 700 posts. My interpretation of the overall thread is that it is an idea to seriously consider and not dismiss out of hand. viewtopic.php?t=75585
Maybe I am realistic, cynical, or rational to believe if folks have a chance to make BILLIONS off an idea using readlily avialable data (CAPE) and computers that can churn data in millicseconds then why are there no funds with this strategy? The only answers could be: They are not smart enough to think of it despite being on Yale, Princeton, and MIT grads or it is not a successful. You do realize Ben Graham wrote about using the similar concept of inverse (Earning yield) to interest rates in his book "intelligent investor" in 1930's. The variations of this idea is not new. I was being generous saying 20 years it is more like the concept was there 50+ years ago.

I agree and have said in past it is NOT about if the markets are perfectly efficient. You and I are not academic writing a paper to be published. The retail investor should ONLY care if they can take advantage of any inefficiencies before arbitrage post fees and taxes more then can be handed with the default option of passive investing. I have not seen any data supporting otherwise. The link you highlighted I added to as well. My big beef was the unbiased data is from the Vanguard paper looking at valuation metrics on a prospective basis using regression. I believe their paper showed P/E and P/E10 of correlation coefficients of 0.37 and 0.41. Correlation yes. Enough to be useful to implement... No. The extremes 12.5% tail on either side did show correlations of 0.8. That has its own issues as well.

As I have said before I am not saying this who wants to believe in bogleheads style passive investing. I wish there was a exploitable strategy. That would mean I would be richer or as rich with less risk That is a good thing! Unfortunately, I have not seen anything to suggest otherwise. Let me know if you figure it out.

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

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packer16
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Re: The CAPEable Portfolio!

Post by packer16 » Sat Jul 15, 2017 9:21 am

I think the idea of using CAPE to time asset allocation is actually introducing a timing risk that may more than offset the expected benefit of a less volatile portfolio. Let me give you a real example I have been following using the LP concept of harvesting the higher expected returns of SCV to allow the holder to have a more conservative (more bonds) asset allocation & obtain the required returns to meet a given objective. I started in the period after the LP article was published in the NY Times in late 2011. The supposition was that you could have a 40 SCV/60 LTB & get the same return as a 60 TMI/40 LTB portfolio. If this is true, you could clearly see the benefit, same return lower risk. However, the return difference between the portfolios since the end of 2011 is 3.3% in favor of the TMI/LTB portfolio. As you can see the supposition was based upon an assumption that SCV has a higher expected return than TMI & that this excess return can overcome any oscillations in value vs. growth over time. However, as I have stated above, IMO there is little or no excess return and just oscillation so you have added risk for no benefit. BTW the growth/value oscillation can be diversified away easily by holding some of the other factor so IMO I do not see why you should expect an excess return with such an easily reproducible strategy.

IMO the CAPE timing benefit is of the same ilk due to the increase of timing risk. So when you are attempting to reduce risk you are increasing it due to timing. Also, given today's low interest rates, the opportunity cost of holding bonds vs. stocks is above average so effects of timing risk on total returns is higher than would be the case if interest rates were higher. Also, these types of strategies have been tried many times in history. Ben Graham described a formula plan (similar to your CAPE plan of increasing bonds when multiples are high and decreasing when they are low) in The Intelligent Investor with his conclusion by the last edition that formula plans do not work for longer stretches of time, in his case over 20 years, & a better way is to hold a static percentage of stocks & bonds vs. timing, p. 42 & 99 of 4th edition.

Packer
Last edited by packer16 on Sat Jul 15, 2017 2:22 pm, edited 3 times in total.
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Castanea_d.
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Re: The CAPEable Portfolio!

Post by Castanea_d. » Sat Jul 15, 2017 11:54 am

Just commenting that I follow a CAPE-based tactical allocation somewhat along these lines, something I adopted after reading “The Intelligent Investor.” My version:

Target equity allocation = 50 - ((CAPE-18)*2)

With the current CAPE pretty much at 30, that gives
50 - (30-18)*2 = 50-24 = 26%

If CAPE goes to its 1920 level of about 5, you get
50 – (5-18)*2 = 50-(-26) = 50+26 = 76%

The idea is that for every point the CAPE goes up, I reduce equities by 2%, and vice versa. I chose 18 as a midpoint (giving a 50/50 allocation) instead of the historical mean of around 16 because of a guess that (as some have said) changes in accounting rules have resulted in a permanently higher P/E. I am not entirely convinced, but enough so as to move my equilibrium level by two points.

I added some endpoints to how far I’ll move the allocation (again, with hat tip to Mr. Graham), keeping it no higher than 75% and no lower than 25. Current conditions thus have me pretty much as low on equities as I am willing to go, so if CAPE goes on up to its 1999/2000 levels, I will simply watch with amazement and keep to a 25% allocation.

Also, I worked a 10% allocation to precious metals into my plan, so I take half of it from equities and half from bonds/cash. Thus my current allocation is:

21% equities – 10% precious metals – 69% bonds/cash

I have not done this long enough to see how it works through a full business cycle. So far, it has meant keeping the metals at allocation (which has taken some doing) and putting pretty much all of my new contributions into bonds, with some selling of equities – my 403(b) where I preferably make allocation adjustments has gone from 100% equities in 2009 to 3% at present, which has pretty much sufficed to get me down to 21% equities overall.

Jack56
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Re: The CAPEable Portfolio!

Post by Jack56 » Sat Jul 15, 2017 2:14 pm

I have never seen any clear evidence that one can make money using CAPE.

Thesaints
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Re: The CAPEable Portfolio!

Post by Thesaints » Sat Jul 15, 2017 3:30 pm

The biggest issue with CAPE, perhaps even bigger than it not being normalized to interest rates, is that it compares today's prices to earnings as old as 10 years. At present, it contains the 2008 recession, with one whole year without earnings. What predictive value could it have as prices in 2018 are concerned ? Also, 10 years ago, Apple was a personal computer company; today they produce phones... the pace of the economy has simply got too fast for brooding over earnings distant in time. CAPE had a raison d'etre maybe 30/40 years ago.

It stands to reason that the correct multiple to compare to bond yields is the P/E projected. Except that projected earnings arw, well, projected and not guaranteed, as in the case of bonds.

magneto
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Re: The CAPEable Portfolio!

Post by magneto » Sun Jul 16, 2017 4:46 am

staythecourse wrote: 1. Where is the math or studies or prospective results to suggest this CAPE idea.
2. No offense to you or the original poster but this idea is about 10 years old or more old. It is not novel. So why isn't it done? No one is interested in making more money? Maybe it doesn't work and that is why?
1. It is difficult to come up with performance data for Adaptive Value Investing (AVI) since various differing assumptions can be made about the history of how any particular investor shifted their funds. The permutations are endless.

2. One of the earlier references seems to be Roger Babson from about 1860.

3. IMHO the success or otherwise of Adaptive Value Investing depends on the Asset Class Valuations alternatives presented to the investor at any particular point in time.

4. Personally have used AVI as the default since starting investing many decades ago with pleasing results.
It had not occured to this investor when starting out, that Constant Ratio (CR) might be a viable alternative !!!
For an uncertain investor CR is indeed a valuable tool and not to be dismissed lightly; and most times investors are indeed uncertain.

5. CAPE is potentally flawed, has specific anomalies at present and anyway should always be used with great care.

6. Many/most of the Valuation Measures medians can drift, likened to a ship swinging at anchor and then sometimes dragging that anchor. This led some investors towards long-term trend/deviation analysis; which personally find dubious as there are no firm foundations.

Would say to OP there is no single simple answer to this question, but try to keep an open mind.
'There is a tide in the affairs of men ...', Brutus (Market Timer)

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JoMoney
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Re: The CAPEable Portfolio!

Post by JoMoney » Sun Jul 16, 2017 9:25 am

bligh wrote:... You could also make it more interesting by having the factor be age based. progressing from 1 when you are starting out to 2.5 or 3 when you are close to retirement.

Is such a portfolio "market timing" ?...
This last part, makes sense if you believe your willingness/ability to take the risks of stocks changes as you get closer to retirement. I don't believe that part of it would be "market timing", it's just making a decision that you're no longer willing to take the risk of stocks. If you took money out of stocks to buy a house or a new computer, I wouldn't see that as "market timing" either.

The part that makes me leery, would be the idea of selling stocks at a high CAPE and expecting that you'll buy them back at a lower CAPE and somehow profit from the system. Even if it had worked in the past with better than coin-flip odds (and I'm not sure that it has), that's not an indication it would work in the future. If it was a sure-fire way to higher returns (or even higher "risk-adjusted" returns) people would actually do it, and it's success would ultimately be it's demise. The aggregate of investors are not going to be able beat each other racing to get in/out before the other guy and somehow create anything extra in aggregate.

Set a level of risk you're comfortable with, average in (and out as appropriate) over time, "Stay the course!"
It's a simple but very effective strategy to ensure you garner a fair share of the markets return and avoids the mistakes of those who get involved in the game of trying to beat the other guy. Very few will garner above average results.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

Thesaints
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Re: The CAPEable Portfolio!

Post by Thesaints » Sun Jul 16, 2017 2:47 pm

Selling stocks at higher CAPE to buy them back at lower CAPE works tragically bad when CAPE becomes lower due to higher "E"'s.

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