Asset allocation
In the red zone
In the last twelve months the Annualized S&P 500 Return (Dividends Reinvested) has been 37.197%. We are clearly in a bull market; one might even say pretty toppy. It’s a fair question to ask if investors should lighten up on stocks. Let’s think about it.
One of the most important elements of investing is asset allocation. That is, the percent respectively allocated to stocks, bonds and other investment asset classes. Every investor needs to have a clear idea of their asset allocation strategy. It is not something to develop on the fly, especially when markets are red hot or alternatively, in the dumper.
Traditional asset allocation
A traditional asset allocation strategy is a fixed percent allocated to stocks, say 60%; a fixed allocation to bonds, say 35%; and the balance cash or near cash. With this approach, when the percentages change in bull or bear markets, rebalancing is carried out. The only issue is the timing of rebalancing. That can be done once a year or more often. Or it can depend on the percentage of imbalance.
An investor following this approach would already have a game plan around rebalancing in the current bull market. It makes sense. It’s not what I do.
Dynamic asset allocation
This is an allocation and rebalancing strategy that depends on calls about economic cycles. In theory, it is supposed to put investors into sectors such as consumer discretionary, resource stocks, technology or banks in their sweet spot of the economic cycle. It is the epitome of foolish market timing.
Discretionary lightening up
In Irrational Exuberance Professor Robert Shiller wrote, with reference to the stock market’s CAPE ratio: “Long-term investors would be well advised, individually, to lower their exposure to the stock market when it is high, as it has been recently, and get into the market when it is low.” (Shiller, 2005 Second Edition) p187 (Emphasis added)
Let’s dig into the Shiller CAPE a bit more deeply and also reflect generally on price/earnings ratios in the stock market today.
Here’s a current chart of CAPE. It shows CAPE at 36 today. What does it mean?
Data courtesy of Robert Shiller
What is CAPE and where does it come from?
In 1988 John Campbell and Robert Shiller published a paper about price/earnings ratios using a ten-year average. Today Shiller publishes his CAPE, a cyclically adjusted (for inflation) Price/Earnings ratio—sometimes referred to as the CAPE 10. It averages the most recent 10 years’ earnings and adjusts them for inflation.
Shiller says that: “The relation between price-earnings ratios and subsequent returns appears to be moderately strong…” and that, “We believe, however, the relation should be regarded as statistically significant.” (Shiller, 2005 Second Edition) p187
Nowadays CAPE is frequently referred to in analysts’ reports and the financial press in discussions about whether the stock market is expensive and what investors can expect in the years to come. It has a credibility that comes from the fact that its creator Robert Shiller has a high public profile and is a Nobel Prize recipient.
A deeper interpretation of CAPE
The following chart of CAPE comes from an article in the Wall Street Journal, November 22, 2013. It displays what may be Professor Robert Shiller’s interpretation of CAPE as falling into three zones – green, yellow and red.
Robert Shiller was interviewed for the Wall Street Journal article. The CAPE reading at the time of the Wall Street Journal article was 25.2. This was higher than the CAPE long term average of 16.5 shown on the chart. The practical question that day was what actions investors should be taking in their portfolios at this level. The article reports: “’At current levels, it’s a concern,’ said the Yale University professor who last month won the Nobel Prize. It suggests ‘you should reduce holdings a bit, that might be reasonable. In the meantime, it is possible the market could keep going up even more.’”
This yellow zone/red zone interpretation means that one would not be in a true danger zone until CAPE gave a reading over 28.8. A reading of 25.2 (at the time of the article) is pretty well in the middle of the yellow zone. It is not clear whether the green/yellow/red zone distinction is Robert Shiller’s or the Wall Street Journal’s. I doubt the Wall Street Journal would have published the zone colours without Shiller’s concurrence. I do note that Shiller said that the reading of 25.2 was “a concern”. The suggestion, one supposes, is that the stock market at that time was priced fairly richly.
In the red zone
As noted in our current CAPE chart, CAPE is at 36 today, well into the red zone.
One other thing to note. Shiller suggested lightening up on stocks in November 2013. From November 2013 to October 2024 the Annualized S&P 500 Return (Dividends Reinvested) 13.030%. With the benefit of hindsight, any lightening up in November 2013 would have missed out on some great returns.
Discretionary lightening up – discussion
The first thing to note about discretionary lightening up is that it is the practice of market timing. Interestingly, Shiller’s original research did not present CAPE as a market timing tool. The only claim it made was that there was a statistical relationship between CAPE and subsequent returns. It was never claimed to be useful as a timing tool.
The main problem with CAPE today is that it suffers from non-stationarity of its key data input – earnings. Earnings is an accounting term. Over the last twenty-five years reported earnings have become increasingly skewed which, in turn, is skewing CAPE and also the simple price/earnings ratio.
We can let Professor Damodaran explain it. Aswath Damodaran is a professor of finance at the Stern School of Business at New York University. His area of focus is corporate finance and equity valuation. He has been described as the world’s foremost expert on the subject of corporate valuation.
In his new book titled The Corporate Life Cycle – Business, Investment, and Management Implications published in 2024, he writes: “When accountants misclassify expenses…as they continue to do with R&D expenses, a capital expense if you follow first principles but one that is treated as an operating expense – the accounting earnings can be skewed significantly.” (Damodaran, 2024) p.132 (Emphasis added)
So, earnings, the key input into CAPE and price/earnings ratios generally, is skewed and has been becoming more and more skewed over the last twenty-five years.
My view is that lightening up in bull markets is an attempt to practice market timing. It doesn’t work and the metrics like CAPE and price/earnings ratios are, in any event, not good indicators.
Back to basics
Philip Fisher summarizes his approach to selling: “If the job has been correctly done when a common stock is purchased, the time to sell it is – almost never.” (Fisher, Common Stocks and Uncommon Profits and Other Writings. 1958,1996) p113
If the reader hears echoes of Warren Buffett, it’s actually the other way round. As I’ve noted elsewhere Fisher was a great influence on Buffett. See my post: How Warren Buffett was influenced by Philip Fisher
I take this to heart. Our family’s financial assets are essentially 100% in stocks. As described in last week’s post, I only exit the stock market in a generalized true stock market bubble. See Sentiment and the four faces of risk
I periodically trim stock positions because we need money to live on. Those sales are like pruning plants in the garden. I prune portions of the weakest stocks in the portfolio. Each sale serves to make the overall portfolio better and stronger. Any other sales (which don’t take place very often), follow the policies described in this post: 19 Cardinal rules on selling stocks
The last position I eliminated was last July. The stock had become wildly overpriced. I described the sale in this post: Selling a big winner is a tricky decision
Conclusion
The question I started with was whether to lighten up on stocks in the current bull market environment. My simple answer is no. I fully recognize that a bear market will set in at some point. My investment process accommodates the robust swings and roundabouts of the stock market.
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