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Stocks are expensive. Time to buy debt? Maybe not Add to ...

Norman Rothery is the value investor for Globe Investor’s Strategy Lab. Follow his contributions here and view his model portfolio here.

It’s relatively easy to figure out when the stock market is expensive. Profiting from that knowledge can be much harder.

One of my favourite market measures is economics professor Robert Shiller’s cyclically adjusted price-to-earnings ratio (CAPE). The ratio is based on the current price of the S&P 500 Index divided by its average earnings over the past 10 years, adjusted for inflation.

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In recent months, the ratio has been hovering near 25, which is well in excess of its long-term average of 16.5. As a result, the market is more expensive than normal.

If the past proves to be prologue, the high ratio doesn’t bode well for investors. The market climbed less than 1 per cent annually, on average, during the decade following similar periods after adjusting for inflation. That’s thin gruel for investors who’ll likely be asking for “more, please.”

But the dire forecast comes with a big dollop of uncertainty. A high CAPE is not an automatic death sentence for returns. In addition, it’s worth considering whether the alternatives are any better. Hiding out in bonds could hurt if inflation overwhelms the low yields they currently offer. That’s why it’s important to look at how well Prof. Shiller’s ratio has fared in the past as a trigger for shifting asset allocation.

Economics professor Wade Donald Pfau investigated the situation in a paper called “Long-term investors and valuation-based asset allocation.” He tracked a portfolio that moved fully into stocks when Prof. Shiller’s P/E fell below its rolling middle, or median, point. At other times, the portfolio held treasury bills.

The timing rule generated average gains of 8.59 per cent annually from January, 1871, to January, 2010. It pretty much kept up with the S&P 500, which sported annual gains of 8.60 per cent over the same period.

But the timing method fared better as a risk-reduction technique, which shouldn’t come as a surprise because it was fully invested in treasury bills almost half the time. Over all, it was roughly 25-per-cent less volatile than the buy-and-hold approach and it suffered a maximum drawdown of only 24 per cent versus a 61-per-cent drawdown for the market.

Despite the moderately encouraging results, I doubt many people would be interested in following such an extreme strategy. After all, investors who are worried about market risk are unlikely to sleep well at night holding a portfolio stuffed to the brim with stocks. Instead, they probably have a long-term asset mix in mind and might want to adjust it slightly depending on market conditions.

Fortunately, Prof. Pfau also considered less radical approaches. He looked at the results of a balanced half-stock and half-bill portfolio, with annual rebalancing, and compared it to a timing portfolio that put 30 per cent of its assets into stocks when CAPEs were high and 70 per cent into them when the ratio was low.

The half-stock and half-bill portfolio gained 7.08 per cent annually from 1871 to 2010 while the 30-70 timing approach climbed 7.78 per cent annually. In this case, the return advantage went to the timing strategy, which also had a lower maximum drawdown.

Over all, there is evidence to suggest that Prof. Shiller’s P/E might be useful as a timing trigger. But it looks like a better risk-reduction tool than a return booster. It also comes with a caveat. After all, there are large number of possible timing strategies and if you look hard enough, you’ll find a few that appear to work by chance alone. But these false positives are unlikely to enrich investors in the future.

Finding a way to evaluate the market is one thing. But, before trading, it’s important to make sure that it’s also a useful asset-allocation tool. That’s why it’s worth thinking twice, or thrice, before making any big changes to your portfolio based on it.

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