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Tactical Asset Allocation: Adjusting Based on Valuations

The most common method for determining your stock/bond allocation is to base the decision primarily upon your age, then make an adjustment based on your personal tolerance for volatility.

The idea is that, over extended periods of time, stocks are likely to outperform bonds. So the longer your investment time horizon, the more you should have invested in stocks.

But one could (quite reasonably) make the case that the likelihood of stocks outperforming bonds over a given period also depends upon:

  • Market valuation levels at the beginning of the period, and
  • Available interest rates at the beginning of the period.

So wouldn’t it make sense to take those factors into account when determining your asset allocation?

Estimating Future Returns

Tactical asset allocation strategies seek to estimate the future return of the stock market over your investment time horizon. Then, you compare that estimated return to the return offered by other investments–most notably TIPS due to their predictable returns–and determine your allocation accordingly.

For example, if the expected return that you calculate for the stock market is no higher than the current rate available on TIPS, it wouldn’t make sense to hold very much in stocks. (Why take on the additional risk if there’s no additional expected return?)

To date, the best method I’ve seen for estimating future market returns is the Gordon Equation, which states that inflation-adjusted market returns must equal:

  1. Dividend yield, plus
  2. Inflation-adjusted earnings growth, plus (or minus)
  3. The effect of changes in the market’s P/E ratio.

Because of the compounding nature of dividends and earnings growth, as we look at longer and longer periods, the first two factors become the primary determinants of return. Over shorter periods, however, changes in P/E play the biggest role in determining return.

Implementation of Tactical Asset Allocation

So how, exactly, should a tactical asset allocation strategy be implemented within the context of an investor’s lifetime? For example, how should you incorporate your age into the equation (if at all)?

My suggestion would be this: The longer your time horizon, the smaller the risk premium you demand. (That is, the younger you are, the smaller the necessary spread between the expected return of stocks and the available return on TIPS.)

Why? Because the longer the period in question, the more confident you can be in the Gordon Equation’s estimate of future market returns. (Reason being that the first two factors–dividend yield and earnings growth–are the more predictable ones. And the longer the period in question, the greater the portion of returns they comprise.)

Causes for Concern with Tactical Asset Allocation

As much sense as it might make to consider market price levels and market interest rates when determining your allocation, there are a few reasons I’ve been hesitant to implement such a strategy with my own portfolio.

First, regarding the Gordon-Equation-based strategy, there’s always that third factor–changes in the market’s P/E ratio–which simply can’t be predicted with certainty. Even if you can say with a fair degree of confidence that the market is undervalued (or overvalued) there’s really no telling when it will correct itself.

Second, no matter what strategy you come up with, it’s going to have a built-in historical bias. That is, it’s going to be optimized to work in conditions that resulted from the chain of events that occurred over the last 85 years or so (the period for which we have market data). How well it will work over the next 85 years is unknown.

Third, there are numerous funds that implement tactical asset allocation strategies. Yet they don’t appear to make up a noticeably disproportionate amount of top-performing funds. Why is that?

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Comments

  1. I’m skeptical. This seems like just another variant of trying to beat the market. As you say, there are already numerous funds that implement tactical asset allocation strategies, and their professionals doubtless understand the situation better than I do. It seems like they would have already driven up (or down) the price of bonds/stocks, and so the current price reflects what’s publicly known about interest rates and current P/E ratios. For risk-tolerant younger investors especially– whose time horizon might well be 40-50 years– it still seems like the best advice is to invest heavily in index funds and dial it back to bonds, TIPS and the like as they age. Granted, there’s no guarantee that stocks will continue to beat bonds over long time horizons, but it seems a surer bet than the asset allocation method outlined above.

  2. Most tactical approaches rely on some form of human judgment about which sectors or asset classes are likely to outperform in the future. In my opinion, this is a serious drawback. By bringing human judgment into the equation, we also invite return-reducing behavioral tendencies. Mike, you alluded to a set asset allocation formula that incorporates tactical factors; well, I think that’s an improvement. Unfortunately, as you mentioned above, the record of tactical and fundamental-driven ETFs has been mixed. The data seems to support that market timing is pretty hard (if not impossible), even among broad-based asset classes.

  3. Great post. I’ve implemented a Tactical Asset Allocation strategy on top of my basic Strategic Asset Allocation. I’m only using Tactical on my share based section of the portfolio. The method I am using is known as the PE10 or CAPE (cyclically adjusted PE). Simply, it is the current Real (after inflation) Price divided by the Average 10 Year Real Earnings.

    As the PE10 increases above its long run average I lighten up on that index proportionally. Similarly the opposite when the PE10 falls.

    I’ve chosen this method as I’ve back tested a couple of indexes and found the following correlations:
    – S&P 500 Price correlation to PE10 = 0.78
    – ASX 200 Price correlation to PE10 = 0.81

    However I’ve also back tested the method to total returns (TR) for the S&P 500 and found the following correlations:
    – S&P 500 1 Year TR to PE10 = -0.21
    – S&P 500 5 Year TR to PE10 = -0.39
    – S&P 500 10 Year TR to PE10 = -0.52

    It was this data that encouraged me to incorporate into my strategy. Only time will tell if this was a good move.

    I blog about this strategy regularly as it is a cornerstone of my investing strategy. Some posts you might find interesting on this are:
    Latest ASX 200 http://retirementinvestingtoday.blogspot.com/2010/03/australian-stock-market-march-2010.html
    Latest S&P 500 http://retirementinvestingtoday.blogspot.com/2010/03/us-s-500-stock-market-march-2010-update.html
    Backtesting S&P 500 for TR http://retirementinvestingtoday.blogspot.com/2010/01/further-reasons-why-i-use-shiller-pe10.html

    Of course always DYOR.

  4. Since no one can predict the future, and most people get their investable money in small periodic increments, value cost averaging makes more sense to me.

  5. This seems like just another variant of trying to beat the market.

    I’m not sure I’d phrase it as such. The stock portion of the portfolio would still be accepting market returns. And the bond portion of the portfolio would still be accepting easily-achievable bond returns (i.e., those available with individual TIPS).

    I think it’s more about coming up with an (admittedly very rough) estimate of what market returns might look like over the time horizon in question, then simply asking whether that estimated return is good enough to merit the risk involved in stock investing.

    It seems like they would have already driven up (or down) the price of bonds/stocks, and so the current price reflects what’s publicly known about interest rates and current P/E ratios.

    I too, am a general believer in the efficiency of markets. That said, I’m not sure that one of the characteristics of an efficient market would be a constant risk premium between TIPS and the stock market.

    ….all of that said, I’m still not implementing such a strategy with my own portfolio (even though I’m obviously considering it).

  6. Hey, if you’ve got the time, resources. and expertise I say go for it but with no more than 20% of your investable assets.
    Also, appreciate what you are up against and remember
    “The market can stay irrational longer than you can stay solvent”- John Maynard Keynes – most famous economist of the 20th century. What many people don’t know about Keynes is that he was a world class investor and that although he made a lot in the end he came close to bankruptcy. Reading his chapter from “The General Theory of Employment, Interest, and Money” is probably one of the most profitable ways investors can spend an hour or so.
    I really like the topics chosen in this blog!

  7. The P/E re-rating/de-rating is surely what makes this approach hard to implement.

    A high P/E rating can leave you with a cheap market 12 months later if the earnings come through and stock prices don’t rise much. Investors who get out presuming it indicates stock prices will fall would miss advances and incur costs.

    Has the market regularly fallen historically when on a low P/E? I don’t know the answer. Low P/E stocks fall all the time though (not just because of underlying business weakness, but because again the earnings growth changes).

    Cyclicals are a great example at the stock level. The time to buy miners is often when P/Es are high after a slump. When they’re on single digit P/Es in the middle of a boom, the best might nearly be over.

    As we’d all expect from you Mike, a great stab at it! 🙂

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