As discussed in previous posts, Professor Shiller's CAPE ratio has been, at best, a blunt market timing instrument. If one waited until his ratio dropped to fair value before buying, one would have missed the entire bull market from 2002 to 2007. However, as I mentioned in my last post, the CAPE ratio can be useful in determining when to rebalance. Rather than rebalance once a year, why not use the extent to which the market becomes overvalued as the trigger?
Today, the CAPE ratio reached 60% overvalued for the first time in this bull market which started in March 2009. For me, that is an automatic trigger to rebalance. Accordingly, I have sold 9% of my equity position to bring it back to its core level. The next trigger point would be if the CAPE ratio were to reach 70% overvalued.
Friday, September 19, 2014
Thursday, July 10, 2014
Shiller's CAPE Versus the 10 year U.S. Treasury Note Yield--an Important Negative Correlation
The Federal Reserve has kept short-term interest rates at zero for more than five years. As a result, the yield on the U.S. Treasury 10 year note ("10 year note") dropped to a low under 1.50% in 2012. This initiative has been taken to avoid a depression -- to inflate the economy out of the great recession. The wealth effect from rising asset prices would kick start consumption. The economy would achieve escape velocity, at which point monetary easing could be withdrawn. We may be close to this inflection point.
I believe a dividend discount model to be the best way to determine the fair value for the Standard and Poor's 500 Index ("the stock market"). To me, fair value is the present value of the future dividend stream discounted to the present. The discount rate chosen for this calculation is vital. A higher discount rate implies a lower fair value; and vice versa.
The yield on the 10 year note is now "artificially" 2.60%. If one plugs a 2.60% discount rate into a dividend discount model, fair value would be much higher than the stock market's current price of 1972. Thus, the stock market would appear to be grossly undervalued. A well-known bond investor recently announced these low rates to be the "new normal". Thus, he suggests, this bull market has a long way to go on the upside. The phrase "new normal" reminds me of the most dangerous phrase in the Wall Street lexicon, "This time it's different!" With respect to what discount rate to use in a dividend discount model, I prefer the 10 year note yield averaged over a much longer period than five years.
Those of you who have been reading my posts know that I believe strongly in reversion to the mean. I seek to normalize earnings, earnings growth, and interest rates-- the most important variables determining fair value for the stock market when using a dividend discount model.
Professor Shiller at Yale has devised a method for normalizing earnings. For each of the last ten years, he adjusts each annual earnings for inflation, totals them, and divides by ten. Then by dividing the current price of the stock market by those earnings, he arrives at the market's adjusted price/earnings ratio. He calls it the CAPE ratio, an acronym for "Cyclically Adjusted Price Earnings" ratio. By dividing his current CAPE ratio by the historical average CAPE ratio, he arrives at the extent to which the market is overvalued or undervalued. (The CAPE numbers are available intraday by googling "Shiller's CAPE".)
With this methodology he eliminates the distortions arising from the profit margin cycle. I have argued that, all other things remaining constant, earnings above trend-line should have a lower than average price/earnings ratio, and vice versa. If one doesn't take the profit margin cycle into account, he is likely to buy high and sell low.
However, one major flaw in Shiller's CAPE ratio is that it fails to adjust fully for the level of interest rates. To test the effect of interest rates on CAPE, I have superimposed the chart of the 10 year note yield on the chart of CAPE over the last fifty years. (CAPE is in blue; Yield is in red.)
From 1964 to 1981, while the yield on the 10 year note rose from 4.2% to 15.2%, CAPE declined from 22.2 to 8.4. From 1981 to 2012, while the yield on the 10 year note declined from 15.2% to 1.5%, CAPE rose from 8.4 to 21.3. I conclude from this negative correlation over fifty years that interest rates have had a significant impact on p/e ratios.
Professor Shiller's data covers a 143 year period. My time interval is 50 years. Below are the various means over these two time periods.
CAPE 10 Year Note
Mean Mean
1871-2014 16.6 4.63%
1964-2014 19.6 6.64%
The CAPE ratio is currently 26.1, suggesting that the stock market is 57% overvalued based on the assumptions of a CAPE mean of 16.6 and the 10 year note mean of 4.63%. However, the current 10 year note yield, 2.60%, is more than 200 basis points below that of Shiller's interest rate mean. As long as interest rates remain so low, the bull market will continue. On the other hand, once inflation begins to rise and the Fed is forced to tighten, an upward move in rates to or beyond the 10 year note mean should result in CAPE's reverting to or below its mean. If that happens quickly, a bear market in stocks would occur.
Observations:
(1)The Fed, by keeping interest rates so low for so long, has heavily borrowed from future investment returns. A thirty year bull market in bonds probably ended in 2012. A secular bear market in bonds has probably begun. For those with very long horizons, such as Generation Xers, such a negative trend constitutes an enormous headwind for both bonds and stocks. The conventional asset allocations should be rethought. At the least, the duration of the fixed income portion should be significantly reduced. Some money should be taken out of stocks as well. The proceeds should be invested in non-correlating alternatives or kept in cash equivalents until mean reversions occur.
(2) For those of us who are retired with much shorter time horizons, the asset allocation decision becomes murky because it depends on how rapidly interest rates rise to the mean. If the adjustment is rapid, then both stocks and bonds would decline significantly. If a slow rise ensues, then the damage could be manageable. The problem is that we are in uncharted territory. Being risk averse, I would advise rebalancing the stock portfolio and placing the proceeds of stock sales into cash equivalents or very short duration treasury notes. The long duration bond portfolio should be eliminated, with the proceeds placed in shorter duration treasury notes. As I have said before, this strategy requires patience and discipline. It is not for everyone.
(3) If the economy stays in slow growth mode without any significant rise in inflation, then interest rates would remain low and the stock market could continue to appreciate. Hard to assign a probability to this occurrence.
(4) A slide into recession, a low probability at this point, would result in a serious downdraft in the stock market--probably as much as 30%. Bonds would appreciate in value even from these low interest rate levels.
On another subject, I intend to alter my rebalancing technique. Instead of rebalancing periodically, such as once a year, it makes more sense to rebalance according to overvaluation or undervaluation levels. That would mean that a melt up or melt down in the stock market could trigger rebalancing more frequently than once a year. I'm not predicting a melt up, but anything can happen.
Professor Shiller's data covers a 143 year period. My time interval is 50 years. Below are the various means over these two time periods.
CAPE 10 Year Note
Mean Mean
1871-2014 16.6 4.63%
1964-2014 19.6 6.64%
The CAPE ratio is currently 26.1, suggesting that the stock market is 57% overvalued based on the assumptions of a CAPE mean of 16.6 and the 10 year note mean of 4.63%. However, the current 10 year note yield, 2.60%, is more than 200 basis points below that of Shiller's interest rate mean. As long as interest rates remain so low, the bull market will continue. On the other hand, once inflation begins to rise and the Fed is forced to tighten, an upward move in rates to or beyond the 10 year note mean should result in CAPE's reverting to or below its mean. If that happens quickly, a bear market in stocks would occur.
Observations:
(1)The Fed, by keeping interest rates so low for so long, has heavily borrowed from future investment returns. A thirty year bull market in bonds probably ended in 2012. A secular bear market in bonds has probably begun. For those with very long horizons, such as Generation Xers, such a negative trend constitutes an enormous headwind for both bonds and stocks. The conventional asset allocations should be rethought. At the least, the duration of the fixed income portion should be significantly reduced. Some money should be taken out of stocks as well. The proceeds should be invested in non-correlating alternatives or kept in cash equivalents until mean reversions occur.
(2) For those of us who are retired with much shorter time horizons, the asset allocation decision becomes murky because it depends on how rapidly interest rates rise to the mean. If the adjustment is rapid, then both stocks and bonds would decline significantly. If a slow rise ensues, then the damage could be manageable. The problem is that we are in uncharted territory. Being risk averse, I would advise rebalancing the stock portfolio and placing the proceeds of stock sales into cash equivalents or very short duration treasury notes. The long duration bond portfolio should be eliminated, with the proceeds placed in shorter duration treasury notes. As I have said before, this strategy requires patience and discipline. It is not for everyone.
(3) If the economy stays in slow growth mode without any significant rise in inflation, then interest rates would remain low and the stock market could continue to appreciate. Hard to assign a probability to this occurrence.
(4) A slide into recession, a low probability at this point, would result in a serious downdraft in the stock market--probably as much as 30%. Bonds would appreciate in value even from these low interest rate levels.
On another subject, I intend to alter my rebalancing technique. Instead of rebalancing periodically, such as once a year, it makes more sense to rebalance according to overvaluation or undervaluation levels. That would mean that a melt up or melt down in the stock market could trigger rebalancing more frequently than once a year. I'm not predicting a melt up, but anything can happen.
s
Friday, June 27, 2014
The Importance of Rebalancing--a Fair Test
The American Association of Individual Investors ("AAII"), with its several hundred thousand members, can have an important influence on the behavior of individual investors. Its May 2014 journal contained an article entitled "The Danger of Getting Out of Stocks During Bear Markets." The author compares, over a 25 year period, three investment strategies, all of which start with 70% in stock funds and 30% in bond funds: 1) selling completely out of stocks after a 20% market decline and reinvesting a year later ("panicking"); 2) holding the stock portfolio throughout ("not rebalancing"); and 3) rebalancing the asset allocation annually ("rebalancing"). The annualized returns were pre-tax. There were no assumed annual withdrawals. Risk is defined as the standard deviation of returns.
Unfortunately, the author chose an interval of time for his study--end of 1988 to end of 2013-- which is biased in favor of not rebalancing. At the end of 1988, the Standard and Poor's 500 Index ("the market") was at fair value. (I use Professor Shiller's CAPE Index for valuation purposes.) At the end of 2013, the market was 50% overvalued. With such an increase in overvaluation during the test period one might expect the strategy of not rebalancing to be preferable to rebalancing.
A fair test would be over a time interval that starts and ends at the same relative valuation level. The market was 50% overvalued at the end of 1995. So I ran a test beginning at the end of 1995 and ending at the end of 2013 using the author's own Excel spreadsheets. The results over the two disparate time periods are shown below.
1988-2013 1995-2013
Return Risk Return Risk
Panicking 7.8% 12.6% 4.9% 11.8%
Not Rebalancing 9.7% 14.2% 8.1% 14.2%
Rebalancing 9.6% 12.6% 8.4% 13.1%
Observations:
1) Both test time horizons demonstrate the problem with panicking. Relative to panicking, rebalancing during the 1988-2013 period resulted in a 23% greater return with equal risk. During the 1995-2013 period, rebalancing generated a 71% greater return with only 11% more risk than occurred with panicking--clearly a preferable risk/reward pairing.
Unfortunately, many individual investors buy high and sell low. Flows into and out of equity mutual funds over time confirm this activity. Panicking epitomizes this behavior. On the other hand, rebalancing involves selling high and buying low or vice versa.
2) During the fair test period, 1995-2013, rebalancing generated 4% more return with 8% less risk compared with not rebalancing--thus, rebalancing is the better strategy over this time period!
In his article, the author of the AAII study deconstructed rebalancing as merely a diversionary tactic--discouraging the individual investor from panicking during a bear market. These results above show that rebalancing accomplishes much more.
3) Even during the author's chosen test period, which I deem biased, the wisdom of not rebalancing instead of rebalancing is debatable. It really depends on one's risk orientation. Being risk averse, I prefer rebalancing. After all, to increase one's risk by 13% to achieve a mere 1% greater return isn't attractive to me. For some, however, it might be.
Where Are We Now?
Right now, Shiller's work shows the market to be 56% overvalued. Being a believer in the concept of reversion to fair value, I am interested in how these three strategies would fare during a period that started with the market 50% overvalued and ended with the market at fair value. Such a period occurred from the end of 1995 to the end of 2008. The figures below show the results of this test.
1995-2008
Return Risk
Panicking 2.6% 12.6%
Not Rebalancing 5.0% 14.9%
Rebalancing 5.8% 13.9%
Observations:
1) Rebalancing is by far the best strategy among these three. In comparison with panicking it generates 123% more return with only 10% more risk. Relative to not rebalancing it returns 16% more with 7% less risk.
2) The annualized return from the best of these strategies is a mere 5.8%. That compares favorably with the recent 2.6% yield on the 10 year U.S. Treasury Note and is why the stock market continues to rise despite its being 56% overvalued. However, were inflation to reach the Fed's 2%+ objective, and the 10 year note yield rapidly to revert to its norm of 300 basis points above inflation, then a prospective 5.8% return for equities would be deemed inadequate compared with a 5% yield on the 10 year note. A bear market would likely ensue.
These observations argue for rebalancing now if one hasn't already done so.
Table 1. Performance of the Three Strategies 1988-2013
Strategy 1: Panicking: Annualized return 7.8% Risk 12.6%
Strategy 2: Not Rebalancing: Annualized return 9.7% Risk 14.2%
Strategy 3: Rebalancing: Annualized return 9.6% Risk 12.6%
Note that panicking generates only 81% of the annualized return from rebalancing with the same risk. Therefore, rebalancing is, by far, the better strategy. From an initial $100,000 invested, panicking ends with a portfolio valued at $702,179; rebalancing with $1,087,803. Many individual investors buy high and sell low. Flows into and out of equity mutual funds confirm this activity. Panicking epitomizes this behavior--not a good strategy. On the other hand, rebalancing involves selling high and buying low. Moral of this story--Don't Panic!
According to this test's results, the wisdom of rebalancing versus rebalancing is debatable. It really depends on one's risk orientation. I, for one, prefer rebalancing. After all, to increase one's risk by 12% to achieve a 1% greater return isn't attractive to me. For some, it might be.
The author deconstructs rebalancing as merely a diversionary tactic -- discouraging the investor from panicking in a bear market. It does accomplish that, but much more as well. Unfortunately, the author chose an interval for his study that is biased in favor of holding the stock portfolio throughout without rebalancing (Strategy 2). At the end of 1988, when the study began, the stock market, as measured by the Standard and Poor's 500 Index, was at fair value. (I use Shiller's CAPE Index for valuation levels.) At the end of 2013, it was 50% overvalued. With that kind of increase in valuation, one might expect not rebalancing to win out over rebalancing. A fair test would be a time interval that starts and ends at the same valuation level. Using Shiller's work, the market was 50% overvalued at the end of 1995. Following are the results for the 18 years from the end of 1995 through 2013 using AAII's Excel spreadsheets.
Table 2. Performance of the Three Strategies 1995-2013
Strategy 1: Panicking: Annualized return 4.9% Risk 11.8%
Strategy 2: Not Rebalancing: Annualized return 8.1% Risk 14.2%
Strategy 3: Rebalancing: Annualized return 8.4% Risk 13.1%
The results of this fair test proclaim rebalancing, Strategy 3, to be clearly superior to not rebalancing, Strategy 2, because the return of Strategy 3 is 4% higher and the risk 7% lower. And Strategy 3, again, is far better than Strategy 1.
The final table shows the results when the period starts with 50% overvaluation, the end of 1995, and ends at fair valuation, the end of 2008.
Table 3. Performance of the Three Strategies 1995-2008
Strategy 1: Panicking: Annualized return 2.6% Risk 12.6%
Strategy 2: Not Rebalancing: Annualized return 5.0% Risk 14.9%
Strategy 3: Rebalancing: Annualized return 5.8% Risk 13.9%
As expected, during a period starting with overvaluation and ending with fair valuation, rebalancing easily trumps not rebalancing. Annualized return for the former exceeds that of the latter by 16% and the risk is 7% lower.
Where Are We Now?
The methodology behind Shiller's CAPE Index valuation model is intended to dampen the distorting effect of the profit margin cycle by taking the average earnings over the last ten years rather than earnings during the last twelve months. Since I believe in the concept of regression to the mean, this approach is appealing to me.
Shiller's CAPE Index is available for a nominal fee. While it is not useful for market timing over a short interval of time; it is useful for periods greater than seven years--very important in retirement planning for those with decades to go before reaching retirement age. It is also useful for selecting test intervals.
Right now, Shiller's work shows the S&P 500 Index to be 56% overvalued. Given the test results above, rebalancing would be appropriate at this time.
I
Unfortunately, the author chose an interval of time for his study--end of 1988 to end of 2013-- which is biased in favor of not rebalancing. At the end of 1988, the Standard and Poor's 500 Index ("the market") was at fair value. (I use Professor Shiller's CAPE Index for valuation purposes.) At the end of 2013, the market was 50% overvalued. With such an increase in overvaluation during the test period one might expect the strategy of not rebalancing to be preferable to rebalancing.
A fair test would be over a time interval that starts and ends at the same relative valuation level. The market was 50% overvalued at the end of 1995. So I ran a test beginning at the end of 1995 and ending at the end of 2013 using the author's own Excel spreadsheets. The results over the two disparate time periods are shown below.
1988-2013 1995-2013
Return Risk Return Risk
Panicking 7.8% 12.6% 4.9% 11.8%
Not Rebalancing 9.7% 14.2% 8.1% 14.2%
Rebalancing 9.6% 12.6% 8.4% 13.1%
Observations:
1) Both test time horizons demonstrate the problem with panicking. Relative to panicking, rebalancing during the 1988-2013 period resulted in a 23% greater return with equal risk. During the 1995-2013 period, rebalancing generated a 71% greater return with only 11% more risk than occurred with panicking--clearly a preferable risk/reward pairing.
Unfortunately, many individual investors buy high and sell low. Flows into and out of equity mutual funds over time confirm this activity. Panicking epitomizes this behavior. On the other hand, rebalancing involves selling high and buying low or vice versa.
2) During the fair test period, 1995-2013, rebalancing generated 4% more return with 8% less risk compared with not rebalancing--thus, rebalancing is the better strategy over this time period!
In his article, the author of the AAII study deconstructed rebalancing as merely a diversionary tactic--discouraging the individual investor from panicking during a bear market. These results above show that rebalancing accomplishes much more.
3) Even during the author's chosen test period, which I deem biased, the wisdom of not rebalancing instead of rebalancing is debatable. It really depends on one's risk orientation. Being risk averse, I prefer rebalancing. After all, to increase one's risk by 13% to achieve a mere 1% greater return isn't attractive to me. For some, however, it might be.
Where Are We Now?
Right now, Shiller's work shows the market to be 56% overvalued. Being a believer in the concept of reversion to fair value, I am interested in how these three strategies would fare during a period that started with the market 50% overvalued and ended with the market at fair value. Such a period occurred from the end of 1995 to the end of 2008. The figures below show the results of this test.
1995-2008
Return Risk
Panicking 2.6% 12.6%
Not Rebalancing 5.0% 14.9%
Rebalancing 5.8% 13.9%
Observations:
1) Rebalancing is by far the best strategy among these three. In comparison with panicking it generates 123% more return with only 10% more risk. Relative to not rebalancing it returns 16% more with 7% less risk.
2) The annualized return from the best of these strategies is a mere 5.8%. That compares favorably with the recent 2.6% yield on the 10 year U.S. Treasury Note and is why the stock market continues to rise despite its being 56% overvalued. However, were inflation to reach the Fed's 2%+ objective, and the 10 year note yield rapidly to revert to its norm of 300 basis points above inflation, then a prospective 5.8% return for equities would be deemed inadequate compared with a 5% yield on the 10 year note. A bear market would likely ensue.
These observations argue for rebalancing now if one hasn't already done so.
Table 1. Performance of the Three Strategies 1988-2013
Strategy 1: Panicking: Annualized return 7.8% Risk 12.6%
Strategy 2: Not Rebalancing: Annualized return 9.7% Risk 14.2%
Strategy 3: Rebalancing: Annualized return 9.6% Risk 12.6%
Note that panicking generates only 81% of the annualized return from rebalancing with the same risk. Therefore, rebalancing is, by far, the better strategy. From an initial $100,000 invested, panicking ends with a portfolio valued at $702,179; rebalancing with $1,087,803. Many individual investors buy high and sell low. Flows into and out of equity mutual funds confirm this activity. Panicking epitomizes this behavior--not a good strategy. On the other hand, rebalancing involves selling high and buying low. Moral of this story--Don't Panic!
According to this test's results, the wisdom of rebalancing versus rebalancing is debatable. It really depends on one's risk orientation. I, for one, prefer rebalancing. After all, to increase one's risk by 12% to achieve a 1% greater return isn't attractive to me. For some, it might be.
The author deconstructs rebalancing as merely a diversionary tactic -- discouraging the investor from panicking in a bear market. It does accomplish that, but much more as well. Unfortunately, the author chose an interval for his study that is biased in favor of holding the stock portfolio throughout without rebalancing (Strategy 2). At the end of 1988, when the study began, the stock market, as measured by the Standard and Poor's 500 Index, was at fair value. (I use Shiller's CAPE Index for valuation levels.) At the end of 2013, it was 50% overvalued. With that kind of increase in valuation, one might expect not rebalancing to win out over rebalancing. A fair test would be a time interval that starts and ends at the same valuation level. Using Shiller's work, the market was 50% overvalued at the end of 1995. Following are the results for the 18 years from the end of 1995 through 2013 using AAII's Excel spreadsheets.
Table 2. Performance of the Three Strategies 1995-2013
Strategy 1: Panicking: Annualized return 4.9% Risk 11.8%
Strategy 2: Not Rebalancing: Annualized return 8.1% Risk 14.2%
Strategy 3: Rebalancing: Annualized return 8.4% Risk 13.1%
The results of this fair test proclaim rebalancing, Strategy 3, to be clearly superior to not rebalancing, Strategy 2, because the return of Strategy 3 is 4% higher and the risk 7% lower. And Strategy 3, again, is far better than Strategy 1.
The final table shows the results when the period starts with 50% overvaluation, the end of 1995, and ends at fair valuation, the end of 2008.
Table 3. Performance of the Three Strategies 1995-2008
Strategy 1: Panicking: Annualized return 2.6% Risk 12.6%
Strategy 2: Not Rebalancing: Annualized return 5.0% Risk 14.9%
Strategy 3: Rebalancing: Annualized return 5.8% Risk 13.9%
As expected, during a period starting with overvaluation and ending with fair valuation, rebalancing easily trumps not rebalancing. Annualized return for the former exceeds that of the latter by 16% and the risk is 7% lower.
Where Are We Now?
The methodology behind Shiller's CAPE Index valuation model is intended to dampen the distorting effect of the profit margin cycle by taking the average earnings over the last ten years rather than earnings during the last twelve months. Since I believe in the concept of regression to the mean, this approach is appealing to me.
Shiller's CAPE Index is available for a nominal fee. While it is not useful for market timing over a short interval of time; it is useful for periods greater than seven years--very important in retirement planning for those with decades to go before reaching retirement age. It is also useful for selecting test intervals.
Right now, Shiller's work shows the S&P 500 Index to be 56% overvalued. Given the test results above, rebalancing would be appropriate at this time.
I
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