The "Rule of 20" gives the investor some insight into valuation level relative to
inflation only. It doesn't suggest a non-emotional, systematic, valuation-based suggestion for an appropriate asset allocation.
Evidence continues to accumulate that systematic approaches beats the opinions of experts. Experts believe they can tell when the market is expensive, and then will make adjustments. It seems many experts rationalized that the market's recent highs were justifiable, and they convinced themselves that the market was not expensive at Shiller P/E 26- 27.
The systematic, formulaic approach can help take the guess work out of AA...
--Shiller proved that earnings
mean-revert. Earnings are the mother's milk of stocks. The Shiller P/E gives us insight into when the earnings are mean-reverting, as we get a strong clue that greedy, or uninformed investors may still be bidding up the prices. We shouldn't be surprised it happens. Time after time, it is shown that investors are notorious for chasing performance.
--As the market gets gradually more expensive, the formula reduces stock allocation reduces. This is in line with the Shiller P/E's message, i.e. reducing expected future returns of stocks, and the increasing risk.
--Higher Shiller P/E readings suggest a increased likelihood of the market falling from current levels
due to valuation rather than as volatility. Some may call this the "dogma." I call it value-investing.
Browser wrote: "... your strategy calls for continually adjusting your equity allocation based on CAPE, which entails short term market timing. "
Any customized approach that references the Shiller P/E doesn't have to be "continual." Graham believe that allocations could be adjusted if the investor perceived that prices were escalated and getting frothy. He offered 25%-50%-75%. Mr. Bogle offered 35%-50%-65%. A defensive investor's stock allocations can be measured and graded. Here's but one example using Vanguard "one stop shopping " funds . I am sure there are folks out here a lot more creative than I am.
Stock allocation = 100 – { 100 x (CAPE – AvgCAPE/2)/(AvgCAPE*2 – AvgCAPE/2) }
The formula's current output is
37% stocks (at Shiller P/E 23.89 and long-term mean of 16.6 as of 9-28-15) ). The investor initiating the strategy today would simply pick a VG Life Strategy fund closed to the formula output --and stick with it ---until the next LS stock threshold was reached ...
--LS Income Fund: 20% stocks
--LS Conservative Growth Fund: 40% stocks / 60% bonds
<= this fund is closest to the current output of 37%.
--LS Moderate Growth Fund: 60% stocks / 40% bonds
--LS Growth Fund: 80% stocks / 20% bonds.
Using the Life Strategy approach above, the next likely landing spot for stock allocation , should the market continue declining, will be the " moderate growth" fund with 60% stocks. To some investors, this is intuitive and make sense because
they want to raise their stock allocation, or go opposite of the crowd, when valuations get more attractive.
Be safe out there
“Everyone is a disciplined, long-term investor until the market goes down.” – Steve Forbes