Most Popular ArticlesSeptember 1, 2009
I decided to take a closer look at how advisors might be able to use Shiller P/E's when managing client portfolios. I ran some tests comparing historic stock and Treasury-bond returns going back to 1928 with the historic Shiller P/E's. I measured returns based on overlapping 10-year periods.
For a base case, I constructed buy-and-hold portfolios of Treasury bonds and stocks with the starting mix set so that the portfolio mix would average 50/50 over the 10-year measurement period. I also constructed 50/50 portfolios based on annual rebalancing. The buy-and-hold portfolios produced an average annualized return of 8.30 percent, and the rebalanced portfolios averaged 8.41 percent.
Next, I incorporated the Shiller P/E's to help determine the asset mixes. In one approach, I used a buy-and-hold strategy by establishing the asset mix at the beginning of each 10-year period based on the then-current Shiller P/E. I developed an algorithm based on targeting a 50/50 initial mix at average levels of the Shiller P/E (around 17), and then varying the initial stock percentage from zero to 100 based on the difference from the average. This could also be called the "Rip Van Winkle" approach, with the portfolio set to run on "auto-pilot" for the duration of each 10-year period. This method produced returns averaging 9.46 percent, a 1.16 percent improvement over the base-case buy-and-hold.
Finally, I tried an approach where, instead of buy-and-hold, I varied the asset mix each year based on the then-current Shiller P/E level. This approach produced an average return of 9.67 percent.
These results have allowed me to conclude that the Shiller P/E's certainly offer information that planners may be able to use in making long-term asset allocation recommendations. I was initially surprised that varying the allocation each year did not produce significantly better results than just setting the allocation at the start of each 10-year period. Apparently annual adjustments end up responding mostly to short-term random movements and momentum effects. Setting the allocation at the start picks up most of the effect of valuation on long-term performance.
To follow an approach like the one I modeled, advisors and their clients would have to hold some extreme positions. For example, the model would have recommended holding less than 15 percent stocks during the years 1995-1999. Annual stock returns averaged over 25 percent during this period, so it would have been a challenge to stick with such allocations. The strategy, however, would have paid off in the long run.
As of late August, with the S&P around 1,000, the Shiller P/E was quite close to its long-term average of 17. For now I'm advising clients to hold allocations at long term targets. If the rally continues and the S&P climbs past 1150, I'll recommend clients cut back allocations to stocks.
is an actuary and a financial planner, and is managing director of Tomlinson Financial Planning, LLC in Greenville, Maine. His practice focuses on retirement planning. He also does research and writing on financial planning and investment topics.
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