Do simple stock market valuation ratios work for tactical allocation? In his April 2015 paper entitled “Multiples, Forecasting, and Asset Allocation”, Javier Estrada investigates whether investors can outperform a 60-40 stocks-bonds benchmark portfolio via tactical strategies based on one of three simple stock market valuation ratios: (1) dividend-price ratio (D/P); (2) price-earnings ratio (P/E); or, (3) cyclically adjusted price-earnings ratio (CAPE, or P/E10). The valuation‐based strategies take aggressive (conservative) stances when stocks are cheap (expensive) via combinations of the following rules:
- Designate stocks as cheap (expensive) when a valuation ratio is below (above) its inception-to-date mean by one standard deviation (1SD) or two standard deviations (2SD).
- Use 60-40 stocks-bonds allocations when stocks are not cheap or expensive. When stocks are cheap (expensive), shift toward stocks (bonds) by 20% to 80-20 (40-60) or by 30% to 90-10 (30-70).
- Rebalance either annually or monthly.
For the benchmark portfolio and the valuation-based portfolios when in 60-40 stance, rebalancing occurs only when the stock allocation drifts below 55% or above 65%. To accrue at least 20 years of data for initial valuations, strategy performance measurements span 1920 through 2014 (95 years). Calculations lag dividends and earnings by three months to ensure real-time availability. Testing ignores trading frictions and tax implications. Using monthly S&P 500 Index total returns and the yield on 90-day U.S. Treasury bills (T-bills) during September 1899 through December 2014, he finds that: Keep Reading