Tactical Asset Allocation During Cheap Markets by Wesley R. Gray, Alpha Architect

In our last post, we looked at tactical allocation using valuation metrics and trend-following measures.

Our conclusion from the analysis is that discerning robust trading signals based on  market valuations is difficult at best.

This research piece attempts to dig a little deeper and addresses the following questions:

  • Opportunity Costs
    • How do other asset classes perform during different CAPE regimes? Why go all-in on equity if bonds are the asset class that outperforms?
  • Diversification
    • Do we abandon diversification and shift heavily into equities following cheap markets?
  • Real Equity Premium
    • CAPE ratios are absolute pricing measures, but what we care about is the equity premium. If equity is expected to earn 15% real and bonds are expected to earn 15% real, equity isn’t cheap.

Strategy Background

The following 3 data series are used in our tests:

  1. LTR: Merrill Lynch 7-10 year government bond index—ML1US10 INDEX
  2. SPX: SP500 Total Return Index—SPXT INDEX
  3. Shiller P/E: Shiller’s Cyclically Adjusted PE ratio—10-year average real earnings /real price

Simulation results are from January 1, 1929 through April 30, 2014.

No transaction costs are included in any of our analysis. All results are gross of any transaction fees, management fees, or any other fees that might be associated with executing the models in real-time. The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Shiller P/E and Market Performance (1/1/1929 to 4/30/2014)

Asset allocation

 

 

See full article here: Alpha Architect