My post describing my plan to shift slowly out of stocks as the CAPE exceeds 25 drew some good comments. Only one comment indicated a lack of interest in such a plan, but I suspect the majority of readers with indexed portfolios intend to stick with a fixed asset allocation that doesn’t take into account the CAPE. For these investors, I wonder if they would keep owning the same percentage of stocks even if the CAPE doubles from its current level into the range of Japanese stocks before 1990. If there is some stock price level at which you’d take some money “off the table”, then the difference between your plan and mine is that I start shifting slowly out of stocks at a CAPE of 25, and your threshold is higher.
I wrote one post in the past two weeks:
What to Do About Crazy Stock Valuations
Here are some short takes and some weekend reading:
Mikhail Samonov explains why trying to use Shiller’s CAPE ratio to make hard switches between stocks and bonds is likely to fail. Some form of dynamic asset allocation that makes gradual shifts between stocks and bonds is more likely to give satisfactory results. My Variable Asset Allocation (VAA) approach is one I designed to try to reduce risk in expensive markets.
Steadyhand keeps tabs on Canadian bank profits. “Nowhere in the world do banks earn this level of profit from their individual customers.”
Justin Bender brings us part two of his series on asset location strategies. He explains the strategy he has named “Ludicrous”. Any DIY investor who truly understands portfolio taxes and how they affect portfolio risk would never use this strategy. It is based on the idea of maximizing your expected portfolio gains subject to the constraint of a particular before-tax asset allocation (BTAA). However, it is your after-tax asset allocation (ATAA) that determines your expected returns and portfolio risk. By following the Ludicrous strategy, you’re taking on more risk than you realize if you’re focusing on your BTAA, and you have all your low-return bonds in a tax-advantaged account. This may be sensible for an advisor who wants to create riskier portfolios than the client realizes, but makes no sense for DIY investors. I understand that there are also regulatory reasons why advisors are constrained to focus on BTAA, even though it is the ATAA that will determine the client’s financial fate.
Friday, December 17, 2021
Short Takes: Dynamic Asset Allocation, Canadian Bank Profits, and more
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My thoughts are while there have been some jumps in the CAPE, there have also been jumps in inflation. And I wonder if once the dust settles, that inflation will raise the profits of companies which will lower the CAPE.
ReplyDeleteObviously this may take a little time, but I still feel like it will help balance things out.
Hi Leo,
DeleteThat's certainly a possibility. If stocks trade sideways for a while as corporate profits rise, this will lower the CAPE, and my strategy will offer no advantage. It's if stocks decline significantly that my VAA protects my current gains.
The question I'd like to hear answers for is "Is there a CAPE level where you would reduce your allocation to stocks?"
DeleteRight now I am in my building phase of my portfolio. Two things: 1) I do have some preferred ETFs for fixed income, but no bonds at the moment. 2) My ratios to keep my portfolio balanced and diversified is maintained as part of my spreadsheet.
DeleteSo every month when I buy, the spreadsheet has calculated how much and what I should buy to bring my portfolio back to the ratios I have set.
So I don't look at CAPE really, but my spreadsheet does make me buy less of the things where price has gone up... kinda factoring that in, without actually looking at CAPE. But I am really just looking at the raitos and moving the portfolio steadily towards what I have set.
Hi Leo,
DeleteHigh stock prices are less serious for someone who is still working and contributing to a portfolio than they are for someone who is retired. If I were still working, I'm not sure whether I would have tried to adjust for the high CAPE, and even if I did, I'm not sure what that adjustment would have looked like.
But I can see your point and once I am out of the building phase, adjusting my ratios of fixed income/stocks based on CAPE will likely be integrated into my strategy.
ReplyDeleteHi Michael,
ReplyDeleteWould you change CAPE in your VAA calculation if a more predictive metric came along? For example, Shiller himself has recently developed something called ECY (Excess CAPE Yield) which corrects for interest rates. He claims that this makes stock look attractive in the current environment.
https://www.forbes.com/sites/danrunkevicius/2021/12/28/the-stock-market-is-the-cheapest-since-1980/?sh=1c0bd7c552be
Anonymous,
DeleteI guess that depends on the what the new measure predicts. I know people try to use CAPE to predict future stock returns. However, I'm using it more to predict the likelihood and severity of a stock market crash. For example, at the time I retired in mid-2017, I decided that it would be sensible to consider a 25-30% stock crash the day after I retired as a possibility for planning whether I had saved enough. If I were retiring today, I'd assume 40% or larger stock decline.
The Excess CAPE Yield (ECY) is an interesting way to compare stocks to 10-year bonds. Because long-term bonds are such an unbelievably bad deal right now, I'm not surprised they make stocks look good. In my case, I don't invest in long-term bonds. My portfolio consists of stocks and essentially cash. As the CAPE gets high, I shift slowly towards cash. But this shift is quite subtle -- no sudden "high conviction" moves. I'd be open to using a different measure than the CAPE for this, but it would have to have a very good story. There is too little independent return data in the world's history to rely much on statistics.