By Greenbackd 

Charlie and I would much rather earn a lumpy 15% over time than a smooth 12%.

–Buffett, Chairman’s Letter (1996)

Can an investor concerned about a big crash use a systematic timing tool to exit the market before the crash without giving up too much return? One possible method for doing so is to use the Shiller PE as a valuation tool, and to move the portfolio into cash at some given level of overvaluation. The backtests below show the returns and drawdowns for exiting at four different levels of the Shiller PE ratio, from aggressive to conservative.

The first option is to simply always remain fully invested in the value decile (measured by price-to-book value). For our present purposes, this is the most aggressive. The three other timed strategies kick out of the value decile when the Shiller PE gets increasingly expensive. Mean, the most conservative kicks into cash when the Shiller PE gets just above its mean (17.6 for the data set).Slightly more aggressive is a strategy that kicks into cash at one standard deviation above the mean (a Shiller PE of 24.8) called 1 Std. Dev., and the next most aggressive kicks out at two standard deviations above the long-run average (a Shiller PE of 32.0) called 2 Std. Dev..

Performance of Value Decile (Price-to-Book Value), Cash and 3 Shiller PE Timed Strategies

Shiller and Value Performance 1926 to 2014 Shiller PE
Shiller PE

Over the period examined, the market (the equally weighted universe from which the portfolios were drawn) generated a compound average growth rate (CAGR) of 13.94 percent. Cash generated an average return of 5.17 percent over the same period. The fully invested value decile generated the best CAGR over the full period at 20.01 percent. The other strategies underperformed to the extent that they remained out of the market: The strategy that kicked into cash at the mean returned 13.4 percent yearly, the strategy that kicked into cash at one standard deviation above the mean returned 18.15 percent yearly, and the strategy that kicked into cash at two standard deviations above the mean returned 19.36 percent compound over the full period.

We expect underperformance for remaining out of the market. This is the tradeoff we make to avoid drawdowns. Is it worth it? Below we examine how much drawdown we avoid by getting out of the market at the different ratios.

Drawdowns to Value Decile (Price-to-Book Value), and 3 Shiller PE Timed Strategies

Shiller and Value Drawdown 1926 to 2014 Shiller PE
Shiller PE

The market had a maximum drawdown in 1929 of 86 percent, and has a Sharpe ratio over the full period of of 0.13. The fully invested strategy had a maximum drawdown of 85 percent, and generated a Sharpe ratio of 0.15. The other strategies generate lower maximum drawdowns, but do so for lower Sharpe ratios: The strategy that kicked into cash at the mean had a maximum drawdown of 69 percent, and the worst Sharpe ratio at 0.11;  the strategy that kicked into cash at one standard deviation above the mean had a maximum drawdown of 80 percent, and a Sharpe ratio of 0.14, and the strategy that kicked into cash at two standard deviations above the mean had a maximum drawdown of 84 percent, and a Sharpe ratio of 0.15.

Drawdowns Relative to the Market for Value Decile (Price-to-Book Value), and 3 Shiller PE Timed Strategies

Shiller and Value Drawdown Relative 1926 to 2014

This chart examines the drawdown to each strategy relative to the market. Where it is below the midline, the strategy has drawn down further than the market, and above the midline it is outperforming.

Benjamin Graham recommended maintaining a minimum portfolio exposure to stocks of 25 percent. Below we re-run the tests, but this time instead of kicking all of the portfolio into cash, we put only 75 of the portfolio in cash, and maintain 25 exposure to the value decile.

Performance of Value Decile (Price-to-Book Value), Cash and 3 Shiller PE Timed Strategies (Graham Rule)

Shiller and Value Performance Graham Rule 1926 to 2014

The additional exposure to the market improves the returns for the three timed strategies. The strategy that kicked into cash at the mean now returns 15.23 percent yearly, the strategy that kicked into cash at one standard deviation above the mean returned 18.67 percent yearly, and the strategy that kicked into cash at two standard deviations above the mean returned 19.55 percent compound over the full period. All still underperform the fully invested strategy at 20.01 percent.

Drawdowns to Value Decile (Price-to-Book Value), Cash and 3 Shiller PE Timed Strategies

Shiller and Value Drawdown Graham Rule 1926 to 2014

The tradeoff for slightly improved returns is greater drawdowns and volatility. The strategy that kicked into cash at the mean had lower a maximum drawdown of 73 percent, but an improved Sharpe ratio at 0.12;  the strategy that kicked into cash at one standard deviation above the mean remained unchanged with a maximum drawdown of 80 percent, and a Sharpe ratio of 0.14, and the strategy that kicked into cash at two standard deviations above the mean had a maximum drawdown of 85 percent, and a Sharpe ratio of 0.15.

Drawdowns Relative to the Market for Value Decile (Price-to-Book Value), and 3 Shiller PE Timed Strategies

Shiller and Value Drawdown Relative Graham Rule 1926 to 2014

The Shiller PE is not a particularly useful timing mechanism. This is because valuation is not good at timing the market (really, nothing works–timing the market is a fool’s or genius’s game). Carrying cash does serve to reduce drawdowns. It also reduces returns. The more conservative the Shiller PE ratio used, the lower the drawdown, but returns suffer, and Sharpe ratios reduce. To generate the extraordinary returns of the value deciles I’ve examined over the last few weeks, it was necessary to remain fully invested in those value stocks through thick and thin. My firm, Eyquem, offers low cost, fee-only managed accounts that implement a systematic deep value investment strategy. Please contact me by email at [email protected] or call me by telephone on (646) 535 8629 to learn more. Click here if you’d like to read more on Quantitative Value, or connect with me on TwitterLinkedIn or Facebook.