CAPE "Sending a False Signal"

[AdrianC]

Shiller’s Powerful Market Indicator Is Sending a False Signal About Stocks This Time
A close look at a Nobel Prize winner’s valuation metric shows that the market isn’t as highly valued as it appears

http://www.wsj.com/articles/powerful-market-indicator-flashes-sell-heres-why-it-can-be-ignored-1475687806

A popular valuation metric pioneered by Nobel Prize-winning economist  Robert Shiller says that stocks are dangerously expensive. But it may be sending a false signal.

Perhaps. There are other indicators showing a high market value (trailing PE, record high profit margins).

[talltexan]

Indeed, the article mentions that the CAPE measure should be taken as a guide when comparing stocks to safe investments (and the safe alternatives right now are not exciting). But I think there's still some value in having SOME nut to use for rebalancing when you have a downturn. Even going 10% into the supposedly over-valued US Bonds would give you that flexibility later.

[Jack]

But I think there's still some value in having SOME nut to use for rebalancing when you have a downturn. Even going 10% into the supposedly over-valued US Bonds would give you that flexibility later.

I'd be interested in a reference quantifying that value (i.e., a study suggesting that a small bond allocation might have higher long-term total returns than a 100% stock portfolio).

[spud1987]

Interesting article. But I'm not sure I buy the revised methodology used by WSJ. As noted, the Commerce Dept data includes all companies, not just public companies. Using this data combined with the Fed Reserve data on stock value gives an apples to oranges comparison.

[AdrianC]

But I think there's still some value in having SOME nut to use for rebalancing when you have a downturn. Even going 10% into the supposedly over-valued US Bonds would give you that flexibility later.

I'd be interested in a reference quantifying that value (i.e., a study suggesting that a small bond allocation might have higher long-term total returns than a 100% stock portfolio).

Try this:
https://portfoliocharts.com/portfolio/heat-map/

Last 20 years CAGR
80/20 5.65%
100 5.36%

Last 15 years CAGR
80/20 3.61%
100 3.41%

For shorter and longer periods 100% stocks wins out.

100% stocks is the winner for accumulation if you can take the volatility.

During retirement it's a different story.

[Rubic]

But I think there's still some value in having SOME nut to use for rebalancing when you have a downturn. Even going 10% into the supposedly over-valued US Bonds would give you that flexibility later.

I'd be interested in a reference quantifying that value (i.e., a study suggesting that a small bond allocation might have higher long-term total returns than a 100% stock portfolio).

In Warren Buffett's 2013 letter to shareholders he specified his trustees are directed
to allocate his wife’s inheritance in the following manner: 90% index funds and
10% in short-term government bonds.

Javier Estrada of IESE Business School did an analysis of this allocation for 30
year periods.  He maintained a 90/10 allocation by rebalancing each year and
assumed a 4% initial withdrawal rate adjusted each year for inflation.  It turns
out that Buffett’s asset mix is pretty good (unsurprisingly, since he's Warren Buffett)
failing in only 2.3% of the intervals tested.

Source: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2680084

[nobodyspecial]

In Warren Buffett's 2013 letter to shareholders he specified his trustees are directed
to allocate his wife’s inheritance in the following manner: 90% index funds and
10% in short-term government bonds.

So if you are the 80 year old widow of a billionaire and probably have enough money in your purse to buy a private jet this is optimal advice.

[AdrianC]

So if you are the 80 year old widow of a billionaire and probably have enough money in your purse to buy a private jet this is optimal advice.

I think Astrid is only 70, and most of Buffett's fortune is pledged to the Gates Foundation. Still, Astrid should be just fine.

The point is Buffett wanted to publish this. That means something. We all know the optimal asset allocation for maximum return. Take out a couple of years in cash for living expenses when stocks are down, and an emergency fund, and you get 90/10.

[MustacheAndaHalf]

Or this could be a message that Warren Buffet wants to sell all his Berkshire Hathaway stock as soon as he's gone, and invest in the S&P 500 instead.

Still, what works for billionaires doesn't necessarily work for every other investor.  90% money market funds and 10% S&P 500 would work just fine for his widow as she withdraws tens of millions of dollars per year.

[Rubic]

So if you are the 80 year old widow of a billionaire and probably have enough money in your purse to buy a private jet this is optimal advice.

Did you read the linked source?

"An obvious distinction between Buffett’s wife and the average investor quickly comes to
mind. The average investor needs to implement an asset allocation that carefully balances
the two risks already mentioned, overspending and underspending. Buffett’s wife, however,
is likely to receive a nest egg large enough so that she will not have to worry about
either risk."

"... this article evaluates the merits of the 90/10 allocation that Buffett advised for
his wife, relative to other static allocations with different stock/bond proportions,
for investors at large."

[Jack]

But I think there's still some value in having SOME nut to use for rebalancing when you have a downturn. Even going 10% into the supposedly over-valued US Bonds would give you that flexibility later.

I'd be interested in a reference quantifying that value (i.e., a study suggesting that a small bond allocation might have higher long-term total returns than a 100% stock portfolio).

In Warren Buffett's 2013 letter to shareholders he specified his trustees are directed
to allocate his wife’s inheritance in the following manner: 90% index funds and
10% in short-term government bonds.

Javier Estrada of IESE Business School did an analysis of this allocation for 30
year periods.  He maintained a 90/10 allocation by rebalancing each year and
assumed a 4% initial withdrawal rate adjusted each year for inflation.  It turns
out that Buffett’s asset mix is pretty good (unsurprisingly, since he's Warren Buffett)
failing in only 2.3% of the intervals tested.

Source: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2680084

Probability of portfolio failure is a different question than what I asked. I'm interested in claims that 90/10 has a higher upside than 100/0 (due to e.g. the "dry powder" of the bond allocation allowing you to take better advantage of downturns). That doesn't seem to be the case using cFIREsim and its annual rebalancing scheme -- average and maximum ending portfolio balance are both lower than for 100/0 -- but maybe some other rebalancing method could work?

[Classical_Liberal]

Even ignoring tax implications of rebalancing between asset allocations, over a long enough period of time, with no drawdown at all,  going with the highest return/volatility investment (stocks) will win out.  Stocks outperform bonds in more years than bonds outperform stocks. If you rebalance every year, more often than not you are rebalancing to a lower return investment.

The only way to change this is to have some form of metric that shows with reliability next year's returns on each investment.  If you find that metric, dont share it with anyone!!

[AdrianC]

Probability of portfolio failure is a different question than what I asked. I'm interested in claims that 90/10 has a higher upside than 100/0 (due to e.g. the "dry powder" of the bond allocation allowing you to take better advantage of downturns). That doesn't seem to be the case using cFIREsim and its annual rebalancing scheme -- average and maximum ending portfolio balance are both lower than for 100/0 -- but maybe some other rebalancing method could work?

https://portfoliocharts.com/portfolio/withdrawal-rates/

Annually rebalanced.
40 years
100% total stock
3.9% SWR

90% total stock/10 total bond
4.2% SWR

30 Years
100% total stock
4.2% SWR

90% total stock/10 total bond
4.25% SWR

Not much in it.

In real life we might expect to reduce expenditure during stock market downturns and so sell fewer cheap stocks.

[Jack]

Probability of portfolio failure is a different question than what I asked. I'm interested in claims that 90/10 has a higher upside than 100/0 (due to e.g. the "dry powder" of the bond allocation allowing you to take better advantage of downturns). That doesn't seem to be the case using cFIREsim and its annual rebalancing scheme -- average and maximum ending portfolio balance are both lower than for 100/0 -- but maybe some other rebalancing method could work?

https://portfoliocharts.com/portfolio/withdrawal-rates/

Annually rebalanced.
40 years
100% total stock
3.9% SWR

90% total stock/10 total bond
4.2% SWR

30 Years
100% total stock
4.2% SWR

90% total stock/10 total bond
4.25% SWR

Not much in it.

In real life we might expect to reduce expenditure during stock market downturns and so sell fewer cheap stocks.

That's still not what I asked. The information I'm looking for is more like "holding the SWR constant, what portfolio allocation would tend to have the highest average return?"

[Classical_Liberal]

Is that true on a risk adjusted basis?  I think you're just saying the most highly levered assets have the highest expected returns, and that's often equities because of where they live in the capital stock and their embedded leverage.  So if you delevered your stocks (e.g., by holding cash) or uplevered your bonds wouldn't the risk v. reward come in line (i.e. risk parity strategies)?  There's no reason why you have to make the stocks the most risky asset...   

I agree with you in total.  I was trying to point out to Jack, in a non drawdown environment, no simple allocation (broad market index) of stocks/bonds with annual rebalance will beat pure equities over the long haul.  Unless, of course, one has the advantage of knowing when each asset class with under/over perform.  As previously stated, the rebalance will lower returns because you are rebalancing toward a less risk/less reward class more often, by definition a higher risk/reward class will outperform more years.

I see now his question was more complex, he wants to know

"holding the SWR constant, what portfolio allocation would tend to have the highest average return?"

  I cannot answer this question as there are too many variables and am not sure what he means by "tend to have" or what the goal is... Highest chance for success over a period of "X" years with "X" withdrawal rate? Highest chance for largest end portfolio value over "X" years? highest withdrawal rate potential over "X" years?  The "highest average return" in drawdown is complex.

[Seppia]

Of course USA stocks are high.
This doesn't mean they cannot go even higher, but with the weak euro and British pound coupled with much more reasonable cape levels, it seems like a great time to add some international diversification.

[Classical_Liberal]

Of course USA stocks are high.
This doesn't mean they cannot go even higher, but with the weak euro and British pound coupled with much more reasonable cape levels, it seems like a great time to add some international diversification.

+1
Developed Europe and many emerging markets look nice from a value standpoint.   IMO Europe's biggest macro problems stem from their own governmental austerity policies and could turn around rather quickly with some policy changes.  Any additional post election US fed rate hikes will probably give us more currency advantage in buying there as well.

[ender]

The world is a scary place by any measure.  I don't think we should be expecting dazzling returns.  But you know what they say under-promise, over-deliver.  Maybe we'll be pleasantly surprised.

The world is a less scary place by every measure I've seen that it has been for the past <pretty much any period of time more than 20 years>.

[Nad]

And with all the shares buyback they're doing now, with "free money", the P/E ratios are misleading. I think stocks are even more overvalued that they try to make it look...

[nobodyspecial]

IMO Europe's biggest macro problems stem from their own governmental austerity policies and could turn around rather quickly with some policy changes. 

Ironic that leftie Keynesian big government stimulus was politicaly possible in the USA but only harsh monetarist, let them starve, the markets must be protected policies were an option with European (cough German)central banks.
Possibly somebody took "Austrian School" a little too literally.

[Classical_Liberal]

IMO Europe's biggest macro problems stem from their own governmental austerity policies and could turn around rather quickly with some policy changes. 

Ironic that leftie Keynesian big government stimulus was politicaly possible in the USA but only harsh monetarist, let them starve, the markets must be protected policies were an option with European (cough German)central banks.
Possibly somebody took "Austrian School" a little too literally.

I know, right! 

Don't get me wrong, as my name implies I tend to think over the long term Keynesian economics is likely a recipe for disaster (probably past my lifetime though).  Forever growth can only happen for as long increasing human population and desires can be supported by a combination of the planet's ecology and continuing ingenuity.  Both likely have limits, or at least diminishing returns. Maybe I'm wrong and some type of discovery like zero point energy will change everything (MMM optimism gun!).

What I dont get... We obviously adopted this system quite a while ago.  In doing so we envisioned better human existence by leveling the boom and bust cycle.  So why in the world would folks choose to abandon it in what is arguably the worst economic times in a generation?  Partially, I suppose, Western Europe is more completely developed than the US, with lower population growth.  Still, though, plenty of new immigrants to spur population growth, all of whom need infrastructure and socialization to their new country (that is, if Western European culture wants to survive in the long run). With negative rates, now would seem to be the time for gov'ts over there to spend.

[nobodyspecial]

The problem is that Germans believe hyper-inflation causes Nazis
Being German they also believe that if the target rate is 2.0% then 2.1% is hyper-inflation
The ECB is the result
 

[steveo]

Forever growth can only happen for as long increasing human population and desires can be supported by a combination of the planet's ecology and continuing ingenuity.  Both likely have limits, or at least diminishing returns. Maybe I'm wrong and some type of discovery like zero point energy will change everything (MMM optimism gun!).

The thing is companies can and will still making profits. If you own stocks those profits go back to you. I don't think you need consistent growth for this to happen. New technologies are discovered. Different stuff booms and crashes. People keep spending.

[Classical_Liberal]

Forever growth can only happen for as long increasing human population and desires can be supported by a combination of the planet's ecology and continuing ingenuity.  Both likely have limits, or at least diminishing returns. Maybe I'm wrong and some type of discovery like zero point energy will change everything (MMM optimism gun!).

The thing is companies can and will still making profits. If you own stocks those profits go back to you. I don't think you need consistent growth for this to happen. New technologies are discovered. Different stuff booms and crashes. People keep spending.

Agreed... BUT... In Keynesian economics there has to be enough growth to cover interest on outstanding debt and/or inflation to reduce the real overall debt owed.  You can't have "just enough" (profits redistributed and spent again by stockholders), you have to have "just enough plus interest" (forever increasing earnings).  This works fine, as long as you have ever increasing humans ans/or needs of humans.  Unfortunately there may be a limit to how many humans and human needs our planet can support.

[Classical_Liberal]

Agreed... BUT... In Keynesian economics there has to be enough growth to cover interest on outstanding debt and/or inflation to reduce the real overall debt owed.  You can't have "just enough" (profits redistributed and spent again by stockholders), you have to have "just enough plus interest" (forever increasing earnings).  This works fine, as long as you have ever increasing humans ans/or needs of humans.  Unfortunately there may be a limit to how many humans and human needs our planet can support.

Hmmm.  In a world like that people would pay a premium for any kind of return.  Returns would be low and it would become harder and harder for those in charge to keep price levels where they want them.  There'd be an incentive for business managers to lever up because of the low cost of debt.  The system would be come vulnerable to all kinds of shocks and miscalculations... science fiction novel?  :)

Excellent idea for a novel!  Perhaps your protagonist could develop some type of metric to determine if a premium was being paid for earnings, to verify his fictional hypothesis .  Maybe something like... a price to earnings ratio, but also cyclically adjusted for economic cycles.  Hell, if the hero had enough data, he could project this metric back through modern history to see if it's mean had been increasing over time.  At the end, he could present his information to the UN, igniting world economic change, all while racing to save the moon girl on space station 76!!

[Metric Mouse]

The world is a scary place by any measure.  I don't think we should be expecting dazzling returns.  But you know what they say under-promise, over-deliver.  Maybe we'll be pleasantly surprised.

The world is a less scary place by every measure I've seen that it has been for the past <pretty much any period of time more than 20 years>.

Thank you Ender. There is so much awesome in this.

[waltworks]

I think the thing here is that if you bet against humanity (ie, everything's going to suck, short the market, stockpile gold and antibiotics and fertile women) historically you lose, even over 10,000+ years. There are some time periods when that doesn't happen but the really important risks to FIRE are IMO (in no particular order):
-Catastrophic climate change
-Nuclear/world war
-Asteroid impact
-Yellowstone erupts
-Various forms of political/economic stupidity triggered by idiot populist politicians of various types

There's also the chance that awesome technological advances (fusion power?) render everyone on earth FIRE because the goods required for life become cheap/free. Think about how different the world is today than it was when someone who is now 90 years old was born! They grew up without *electricity* or *antibiotics* or (for all practical purposes, especially outside the US/Europe) electronic communications of any kind!

You can't control or really plan for any of this in any meaningful way, so why not invest on the historically winning side - ie, optimistically? Worst case scenarios are exactly the same - the meteor falls on your head. Best case scenarios are all WAY better.

-W

[Classical_Liberal]

I agree with the article in that the CAPE is high because of low yields on treasuries.  Risk adjusted premium for equities isn't that far off of norm. 

I disagree that this means US stocks are priced well for the long term.  Instead, it's more likely returns for all asset classes in the US will be well below mean in the coming decade.  Many of the numbers look a lot like the mid to late 60's.  High CAPE, low treasury yields, low inflation. 

From a social standpoint: Large population bubble now reaching 20's-30's but not yet in peaked earning years.  Long term conflict that has "hot" and "cold" periods (although the war on terror doesn't eat up nearly as many resources as the cold war did). Unrest due to racial discrimination.

Other similarities:  Perhaps an upcoming change in how world reserve currency is handled (ie SDR instead of USD).  Unstable oil prices. Acid rain...er I mean, climate change spending required.  At least we don't have Nixon on the horizon, unless... Trump?

Bottom line, humans survived the 1960's/70's and we will survive the 2010's/20's. Will we see stagflation and/or low real returns for the next 15 years?  I have no idea! I just think it's smart to treat our investments more like it's the mid/late 60's than the mid to late 80's, because it is. I still think 4%WR is solid. I'd even FIRE on 5%WR because even at my ripe old age of 40, I know I'm going to somehow earn some income over the next 45 years.

[NathanDrake]

Late 60s/Early 70s, we also had huge oil shocks that contributed to high inflation.

Mid to late 80s resulted in the Oil crash that send energy prices tumbling and inflation was kept in check. The 80s growth in stock prices was despite lowered earnings, so there was P/E expansion during this period. I'd argue we're probably in a situation more similar to the mid to late 80s than the late 60s/early 70s.

I think P/E is really hard to use as a basis for returns when there's so much central bank involvement, changing (more stringent) accounting standards. How can every asset class be overvalued? In my view, bonds are so highly overvalued that in a rising interest rate environment money will move out of bonds and into something else....likely stocks, because interest rates will only rise if the economy starts heating up which will be a good thing for stocks, I'd imagine.

Regardless, there are asset classes that probably ARE undervalued right now -- international stocks in particular. If you believe in holding a globally diversified portfolio, 4% is probably quite safe still.

[ender]

Bottom line, humans survived the 1960's/70's and we will survive the 2010's/20's. Will we see stagflation and/or low real returns for the next 15 years? .

1937 is another interesting comp.  Sputtering recovery from a big downturn, rise of populist politics, monetary policy pullbacks, stretched valuations...

Course, the 1941-1945 years were a bit different worldwide than what most people expect at any point in the next few decades.