Executive Summary
As the popularity of tactical asset allocation and using market valuation to inform investment decisions rises, so too do the criticisms to such methodologies. In the long run, this is part of a healthy dialogue that shapes the ongoing evolution of how we invest. But much of the recent criticism to being tactical in particular seems to suggest that if we can't get the timing exactly right, or calculate a valuation that works precisely to predict returns in all environments, that it should be rejected. In reality, though, even just participating in a few booms, or avoiding a handle of extreme busts, can still create significant long-term benefits for achieving client goals. Which raises the question - if we're really focused on the long term for clients, are we expecting too much from market valuation in the short term?
The inspiration for today's blog post comes from an article recently sent to me by another planner. The article, from the AAII Journal, was entitled "A Cautionary Note About Robert Shiller's CAPE" by Stephen Wilcox, and discussed a series of criticisms to the increasingly popular use of Shiller P/E10 (a P/E ratio where the denominator uses a 10-year trailing average of inflation-adjusted as-reported earnings, also known as the Cyclically Adjusted Price/Earnings ratio {CAPE}). Given our recent article in the Journal of Financial Planning on using market valuation to implement tactical asset allocation, he was curious for my thoughts about the AAII article's criticism of CAPE.
The AAII article went into some good depth regarding challenges in how P/E10 is calculated. For instance, earnings are adjusted for inflation so that the P/E ratio will be measured using real earnings, but the methodology the government uses to calculate inflation has changed over the recent decades. Consequently, today's inflation-adjusted earnings may not quite be analogous to real earnings in more distant historical time periods. In addition, accounting standards have changed over time - especially relative to how earnings and balance sheets were reported in the late 1800s when Shiller's time series begins - so our calculation of the P/E ratio over time has not been entirely consistent with respect to the earnings (which is further exacerbated by the fact that corporations were not taxed for over 1/3rd of Shiller's historical data, and it's entirely possible and plausible that taxation has changed some of the incentives for whether/how companies report earnings over time). Furthermore, Shiller's P/E10 uses, as the name implies, a 10-year average of inflation-adjusted earnings, which is done to smooth out the fluctuations of the business cycle. However, the average business cycle is closer to 6 years than 10 years; consequently, Shiller's P/E10 may be measuring something closer to 1.5 business cycles than just 1, which could cause it to become somewhat distorted over time (as it will be tiled in one direction in the midst of a boom-bust-boom 1.5 cycles, but another if it's in the bust-boom-bust phase).
So what's the outcome of all these criticisms? It seems the primary implication is that the long-term historical average of P/E10 - which we use to evaluate if the market is over- or under-valued - might not really be the 16.4 that the current historical data implies. It might be a bit higher or lower. In addition, we might arrive at a different conclusion regarding the P/E10 in today's marketplace if we calculate it differently - for instance, using 6 years of trailing earnings instead of 10. In fact, the AAII article notes that if we calculated P/E6 (i.e., using 6 years of trailing real earnings) as being representative of cyclically-adjusted price-earnings (CAPE) instead of P/E10, the long term average P/E would be 15.78 (instead of 16.41), and the current valuation (as of July 2011 when the article was being written) would be 21.26 instead of 23.35. The end result of this adjustment alone? Instead of suggesting that the market is 42.3% overvalued (using P/E10), it would only be 34.7% overvalued using P/E6.
To which all I can reply is... who cares!? Even with the author’s own adjustments, the CAPE is screaming that the market is overvalued. Perhaps after the market falls 35%, where the author’s CAPE suggests the market is “fair value” and Shiller’s P/E10-based CAPE suggests the market is still 7.6% overvalued, we can debate whether the market really has to fall another 7% (after the first 35%), or if it’s done. Either way, both methodologies “predict” at least a nearly 35% overvaluation, implying severely substandard returns in the coming years! Similarly, while the author suggests that the long-term historical average for CAPE might be adjusted for changes in inflation or accounting standards, nothing in the author’s discussion ever suggests that CAPE could be off by anywhere near 42.3%. In other words, depending on what adjustments you want to apply, maybe the market is 42% overvalued, or maybe it’s 35%, or maybe it’s 30%, or maybe there’s an unforeseen factor in the other direction and it’s 50%. Regardless, all of these results imply huge overvalued and the elevated risk of a severe market decline; do we really care who's most precisely right in the midst of such a meager prediction of forward returns. Are we really going to debate the last 7% of a 42% market decline? Are we completing missing a raging forest fire by focusing on the health of the individual trees?
So the bottom line is that while CAPE may have some minor flaws that make a pinpoint precision of valuation difficult, nothing the AAII author writes suggests that it is in any way incorrect at such extremes as 40%+ overvalued. In point of fact, that is the primary reason why we only focused on making tactical trades to adjust equity exposure at (good or bad) extreme valuation levels in our recent Journal article.
In other words, the purpose of using valuation is not to debate the last few percentage points of potential market movement in an effort to pinpoint the precise expected return and potential risk of equities to the last decimal place. The purpose is to know when stocks are priced for screaming gains that we can participate in, and to know when stocks are priced for screaming losses that we can reduce our exposure to. The rest of the time, perhaps, we can just go along for the ride and take what the market gives us (although when such a valuation approach is applied across all asset classes, inevitably there are always undervalued opportunities to capitalize upon and/or overvalued pitfalls to avoid). Even just participating in the rare opportunities and avoiding the major pitfalls have a significant enhancement to long-term returns and risk, not to mention the success in achieving client goals.
So what do you think? Is valuation-informed investing only relevant at market extremes? If it IS only relevant at market extremes, is that still acceptable? Does valuation have to be "right" more often, or are we expecting too much? Are we missing the forest for the trees?