Stock Tapering: Adjusting Your Asset Allocation Based on the Market Price-Earnings Ratio

Current stock market prices are high compared to corporate earnings.  What should investors do with this fact?  Index investors are told to ignore the possibility of a stock market bubble and stick to their plans.  Is it possible for investors to adjust their asset allocations to take into account market “priceyness” in a mechanical strategy that doesn’t involve gut-based decisions?  Here I examine one possible approach I call Stock Tapering.

One popular measure of stock market levels is Robert Shiller’s Cyclically Adjusted Price-Earnings Ratio (CAPE Ratio).  As I write this, the CAPE stands at 34.86, a level only seen once before during the late 90s tech boom when it peaked at about 45.

As an index investor, I’m not interested in making active decisions like market timers who may decide to sell all their stocks because their trick knees tell them stocks are going to crash.  I’m also not interested in mechanical strategies that make hard switches such as selling all stocks whenever the CAPE exceeds 40.

Stock Tapering

Suppose I decide to stick with my “normal” asset allocations whenever the CAPE is below 35, but multiply my stock allocation by 35/CAPE when the CAPE is above 35.  For example, my current plan has me 80% in stocks.  However, if the CAPE gets to 40, I’d reduce my stock allocation to 80%*35/40 = 70%.  If the CAPE kept rising to 50, I’d lower my stock allocation to 56%.  Let’s call this P/E-informed asset allocation strategy Stock Tapering.

The theory behind Stock Tapering is that a market crash is more likely when stocks are high, and having a lower stock allocation would save money during a crash.  As long as the calculations are automated in a spreadsheet, it wouldn’t be too hard to combine these stock allocation adjustments with normal portfolio rebalancing operations.

We can certainly imagine scenarios where this CAPE-based asset allocation adjustment could work very well.  But what are the risks of this strategy?

CAPE Rises to 50 and Stays There

Suppose that stock prices keep rising until the CAPE is 50, and then it stays near that level for decades because there has been a permanent reduction in market risk aversion.  The result is that with Stock Tapering, you’d have a permanently reduced stock allocation leading to lower returns for the rest of your life.

However, in the short term you’d get the benefit of huge portfolio growth as the CAPE rose from the current 34.86 to 50.  If you’re already retired with a substantial portfolio, this increase would likely make up for decades of slightly lower future returns, so this scenario wouldn’t be much of a risk.

Note that if you chose 25 instead of 35 as the CAPE level where you start lowering your stock allocation, you may not fare so well if the CAPE stays in the 35 range for decades.  This is because the CAPE is already near 35 today and you’d never get the portfolio boost of the CAPE rising from 25 to 35.

CAPE Rises to 50 Because Corporate Earnings Drop

In the previous scenario, we assumed that the CAPE moves up and down mainly because of movements in stock prices.  What if the CAPE rises because of a big drop in corporate earnings?  The result is that with Stock Tapering, your future reduced returns due to a lower stock allocation would make this strategy work out poorly.

Earnings Volatility

Imagine for a moment that stock prices stay constant for a period of time, but corporate earnings move up and down.  The Stock Tapering strategy would trigger rebalancing trades that increase costs but don’t produce any profits.

Conclusion

In general, with any scenario where we have CAPE changing due to stock price movements, Stock Tapering works well, but it reacts poorly to earnings volatility.  On balance, I don’t know if Stock Tapering is a good idea.  Without further analysis that leads to a favourable outcome, I’m not inclined to try it.  So, I still don’t have a good idea for how to adjust my asset allocation in the face of soaring stock markets.