This article is a follow-up to one I posted several weeks ago (What Other Bloggers Think of Valuation-Informed Indexing — Part One). Valuation-Informed Indexing is a new model for understanding how stock investing works, intended as a replacement for the Buy-and-Hold Model. The one difference between the two models is that, while Buy-and-Holders argue that there is no need to time the market, Valuation-Informed Indexers believe that investors must change their stock allocations in response to big shifts in valuation levels if they are to keep their risk levels roughly constant over time.
The articles link to and quote from blog entries discussing Valuation-Informed Indexing in an intelligent way (and in some cases to my responses to those articles). The bloggers who wrote these articles do not necessarily endorse Valuation-Informed Indexing or believe that Buy-and-Hold needs to be replaced. They believe that Valuation-Informed Indexing possesses enough potential appeal that we all should be comparing the two models and over time coming to reasoned conclusions as to what is the best path for the future. Part Two also contains links to discussion-board threads on Valuation-Informed Indexing hosted at the Bogleheads Forum.
1) The Truth About the Shiller PE — Bad Money Advice
Juicy Excerpt #1: Valuing the market relative to its own history, that is, comparing the current price to the long-run average, implicitly makes the assumption that there exists some kind of true or natural price level for the stock market. That might very well be the case, but it is an awfully big assumption to bake into the analysis without further ado.
Juicy Excerpt #2: Using monthly observations of CAPE and the 10-year forward real stock market return from January 1881 to January 2000, I get a correlation of -0.44. That corresponds to an R squared of 0.19, which is impressively strong in the world of finance.
Juicy Excerpt #3: Things get weird fast if you suppose that CAPE works on ten-year but not one-year horizons. Are we to make only ten-year stock market commitments?
Juicy Excerpt #4: The practical sample size is a lot closer to 12 than it is to 140. Which raises the specter that this could be just “a chance relation with no significance.”
2) The CAPE: How to Beat Stocks with a 50/50 Portfolio — Invest It Wisely
Juicy Excerpt #1: Figure 1 shows the annualized real return over the next 20 years as a function of the current CAPE. When the CAPE was below 10, the return of the S&P 500 has never been below 5% p.a. over the next 20 years (i.e., one at least multiplied one’s purchasing power by 2.7). And it has never been above 3 percent when the CAPE was above 23. (This does not mean that this will never happen, just that it is quite unlikely.) With the 1999-2000 CAPE of more than 40, it is hard to see how one could dream of making money in the long run.
Juicy Excerpt #2: The CAPE strategy can return about as much as stocks, but with lower volatility (14% against 19%), and with much smaller drawdowns (drops from peak to trough), as shown by Table 1.
3) All Studies That Support Buy-and-Hold Are Analytically Invalid — Out of Your Rut
Juicy Excerpt: Many Buy-and-Holders have been thinking since 1996 (when valuations first reached dangerous levels) that Buy-and-Hold has been producing good results. But the good results were largely a function of overpricing. When portfolio values are adjusted for the effect of overpricing (as they always should be, according to Valuation-Informed Indexers), the gains achieved during a bull market are less impressive.
4) The Pros and Cons of Valuation-Informed Indexing — Bogleheads Forum
Juicy Excerpt #1: It’s just another way of saying “Tactical Asset Allocation (TAA).” Jack Bogle wrote about TAA in his books. So the concept is not new to Bogleheads.
Juicy Excerpt #2: Differences in opinion is what makes horseracing and difference in opinion on valuation is what makes the stock market…. I just don’t believe that a few simple rules based on numbers that are easily available to everyone will substantially improve your risk-adjusted returns.
Juicy Excerpt: Here is a observation. There’s a fair amount of skepticism in this thread (even some hostility) to Professor Pfau’s research on valuation-based market timing. Yet every day there are posts on this forum that advocate valuation-based market timing in other asset classes. For example, many people on this forum consider it OK — even prudent — to buy TIPS when real yields are high. Why is valuation-based market timing of TIPS perfectly OK whereas valuation-based market timing of equities is not?
Juicy Excerpt: In the mid-90s, was not the P/E10 ratio (>25) already saying the market was overvalued? If you had followed P/E10 you would have been underweight stocks during one of the biggest 5-year bull market runs of the 20th Century. P/E10 eventually peaked above 40. While you would have been under-weight during the subsequent decline, the starting point would have been lower having been under-weight the previous five years.