Misunderstanding of using CAPE for equity allocation

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CULater
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Misunderstanding of using CAPE for equity allocation

Post by CULater » Wed Sep 26, 2018 9:07 am

Something I've never understood about using CAPE as a timing strategy to increase or decrease equity allocation. It's well accepted knowledge that CAPE does not correlate well with short term equity returns (5 years or less) but does correlate with long term equity returns (10 years or longer). that is, if you are to realize the predictive benefit of CAPE timing, that benefit is realizable only over a 10-year holding period or longer.

Here's the thing. Let's say that CAPE exceeds 35 today, and based on my CAPE policy, I reduce my equity allocation to 25%. I'll need to hold that new allocation for at least 10 years, regardless of what CAPE does in the meantime, yes? It's a long-term timing strategy. But that's not what people do who advocate and use CAPE timing. They shift their allocation continuously based on CAPE. That's actually a short-term timing strategy; whereas CAPE is a long-term timing strategy. Actually, if you use the value of CAPE today to determine your stock allocation then you're pretty much locking into that allocation for the next 10 years or longer if you understand how using CAPE is supposed to work. Doesn't make much sense to me.
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yohac
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Re: Misunderstanding of using CAPE for equity allocation

Post by yohac » Wed Sep 26, 2018 9:33 am

Even Shiller says not to use CAPE for market timing. Because it doesn't work, unless you apply backtests to decide how high is high and how low is low. CAPE in 2009 - in retrospect - was a historic low and the buying opportunity of a lifetime. But by historical standards it was only average. Someone waiting for a single digit CAPE, like we had at other low points in history, would have missed out.

alex_686
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Re: Misunderstanding of using CAPE for equity allocation

Post by alex_686 » Wed Sep 26, 2018 9:40 am

I am missing a step here:

1. High CAPE suggest low long term returns.
2. ???
3. Reduce equity holdings.

How do you go from step 1 to step 3?

When I see this I have a different reaction. In order to meet my financial goals I will need to:
1. Reduce my goals. My investments will be earning less.
2. Increase my savings. A variation on #1.
1. Increase my equity percentage, decease bonds. If I keep my required return constant, and foretasted returns fall, I will need to load up on more risk.

All of these are exactly opposite of what you are suggesting.

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Artsdoctor
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Re: Misunderstanding of using CAPE for equity allocation

Post by Artsdoctor » Wed Sep 26, 2018 2:22 pm

CULater wrote:
Wed Sep 26, 2018 9:07 am
Something I've never understood about using CAPE as a timing strategy to increase or decrease equity allocation. It's well accepted knowledge that CAPE does not correlate well with short term equity returns (5 years or less) but does correlate with long term equity returns (10 years or longer). that is, if you are to realize the predictive benefit of CAPE timing, that benefit is realizable only over a 10-year holding period or longer.

Here's the thing. Let's say that CAPE exceeds 35 today, and based on my CAPE policy, I reduce my equity allocation to 25%. I'll need to hold that new allocation for at least 10 years, regardless of what CAPE does in the meantime, yes? It's a long-term timing strategy. But that's not what people do who advocate and use CAPE timing. They shift their allocation continuously based on CAPE. That's actually a short-term timing strategy; whereas CAPE is a long-term timing strategy. Actually, if you use the value of CAPE today to determine your stock allocation then you're pretty much locking into that allocation for the next 10 years or longer if you understand how using CAPE is supposed to work. Doesn't make much sense to me.
Of course there are people who misuse CAPE for short-term planning purposes. Try to ignore them.

If you're going to use CAPE, it's going to be for a long-term projection of earnings. If the CAPE is high, then you're going to be thinking that your returns are going to be muted. You're going to want to factor that in to your portfolio projection in order to figure out if you're on target to meet your goals. It doesn't necessarily affect your asset allocation--if the CAPE is high and your returns are expected to be less than what you had earlier projected, you can keep the same asset allocation, save more, and/or spend less. If you're closing in on retirement and the CAPE has been running high, you may find yourself in a position where your portfolio is much larger than you originally projected--so you can easily trim those equities. Conversely, if you're young and the CAPE is high, you may say that you should be taking more risk (thinking that a higher equity allocation will ultimately be needed) in order to meet your projections and you'll find yourself increasing your equity allocation.

JBTX
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Re: Misunderstanding of using CAPE for equity allocation

Post by JBTX » Wed Sep 26, 2018 10:22 pm

CULater wrote:
Wed Sep 26, 2018 9:07 am
Something I've never understood about using CAPE as a timing strategy to increase or decrease equity allocation. It's well accepted knowledge that CAPE does not correlate well with short term equity returns (5 years or less) but does correlate with long term equity returns (10 years or longer). that is, if you are to realize the predictive benefit of CAPE timing, that benefit is realizable only over a 10-year holding period or longer.

Here's the thing. Let's say that CAPE exceeds 35 today, and based on my CAPE policy, I reduce my equity allocation to 25%. I'll need to hold that new allocation for at least 10 years, regardless of what CAPE does in the meantime, yes? It's a long-term timing strategy. But that's not what people do who advocate and use CAPE timing. They shift their allocation continuously based on CAPE. That's actually a short-term timing strategy; whereas CAPE is a long-term timing strategy. Actually, if you use the value of CAPE today to determine your stock allocation then you're pretty much locking into that allocation for the next 10 years or longer if you understand how using CAPE is supposed to work. Doesn't make much sense to me.
I'm not sure you are looking at it correctly.

If cape = 35 it suggests lower long term returns, from that point. Most likely, on average, 10 years plus that point will have lower returns.

What I'm not clear on is how you act upon that. If you lower equity allocation in reaction, where do you redirect the money? It is likely long term bonds will also have low returns. You could park it in cash, and wait for lower capes, but I'm not sure how effective it is as a timing indicator.

Just because something has some mixed predictive power of long term stock returns doesn't necessarily mean it has meaningful value as a portfolio allocation timing indicator.

My own hunch is it probably won't really gain you much of anything in long term returns, but it might improve your risk/return relationship. But the problem is it may take very strong conviction, because Cape can stay high or low for very long periods of time.

Years ago I took the Schiller data and tried to model market timing strategies over 100+ years using cape. You could come up with superior models, but they bordered on a absurdly impractical. Strategies like selling at 25 and buying at 15 did worse than 100% equity, although perhaps it lowered risk. Problem with such models is they kept you out of the market almost the entire time from 1993 to present. To beat the market you ended up needing strategies like buying at 8 and selling at 32. You could change the multiples just a few points and get dramatically different results. And results also varied a lot depending on where you started, and whether you included great depression years.

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jeffyscott
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Re: Misunderstanding of using CAPE for equity allocation

Post by jeffyscott » Thu Sep 27, 2018 8:55 am

CULater wrote:
Wed Sep 26, 2018 9:07 am
Let's say that CAPE exceeds 35 today, and based on my CAPE policy, I reduce my equity allocation to 25%. I'll need to hold that new allocation for at least 10 years, regardless of what CAPE does in the meantime, yes? It's a long-term timing strategy. But that's not what people do who advocate and use CAPE timing. They shift their allocation continuously based on CAPE. That's actually a short-term timing strategy; whereas CAPE is a long-term timing strategy. Actually, if you use the value of CAPE today to determine your stock allocation then you're pretty much locking into that allocation for the next 10 years or longer if you understand how using CAPE is supposed to work. Doesn't make much sense to me.
If you have reduced to 25% based on CAPE = 35 and then next year CAPE is 15 (which would mean the price has dropped by 50% or so), you would increase your stock allocation because they are now cheaper.
press on, regardless - John C. Bogle

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