Eureka! A Valuation-Based Asset Allocation Strategy that Might Work

Finanza Operativa di Finanza Operativa 27 Agosto 2015 | 13:00

A cura di Wesley R. Gray, Alpha Architect
We’ve had a few posts showing that asset allocation systems relying on market valuation indicators (e.g., Shiller CAPE ratios) as a timing signal may end up in disappointment…

Nonetheless, we’ve continued on the quest to improve tactical asset allocation using market valuation data. The data speaks clearly when it comes to the association between valuations and long-term realized returns–high valuations are associated with low long-term realized returns. However, as Michael Kitces highlights, tactically allocating using valuation information is challenging. Moreover, there are arguments that the association between CAPE and LT returns may be more complex than previously thought.
In short, valuation-based asset allocation strategies haven’t been that exciting…but
The folks at Gestaltu inspired us with a unique twist on basic valuation-based timing methodologies:

…we chose the cyclically adjusted earnings yield as the valuation metric, which is just the reciprocal of the Shiller PE. We then adjusted the yield value for the realized year-over-year inflation rate to find the real earnings yield. Finally, we used an ‘expanding window’ approach to find the percentile rank of the real earnings yield to eliminate as much lookahead bias as possible.
Note that because we are using real earnings yield rather than nominal earnings yield, markets can get cheap or expensive in three ways:

  1. changes in inflation
  2. changes in earnings
  3. changes in price

Gestaltu’s post used 1/CAPE as the valuation metric, or the “earnings yield,” as a baseline indicator; however, they “adjusted the yield value for the realized year-over-year (yoy) inflation rate,” by subtracting the year-over-year inflation rate from the rate of 1/CAPE.
To summarize, the metric looks as follows if the CAPE ratio is 20 and realized inflation (Inf) is 3%:
Real Yield Spread Metric = (1/20)-3% = 2%
Fairly simple.

Strategy Background:

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