Swedroe: Valuations And Asset Allocation

October 20, 2014

The answer is very nuanced.

One of the questions I’m asked with great frequency is to describe how market valuations should impact your financial plan. As I discuss in my book, “The Only Guide You’ll Ever Need for the Right Financial Plan,” there are three very important factors to consider when developing your financial plan, and specifically in determining your asset allocation. They are: the ability, the willingness and the need to take risk.

The ability to take risk is determined both by your investment horizon and the stability of your labor capital. The willingness to take risk (risk tolerance) is determined by your stomach’s ability to handle the stresses caused by bear markets. And the need to take risk is determined both by your spending requirements (the higher they are, the greater the need) and the expected rate of return on your investment choices (which are determined by market valuations and bond yields).

Thus, valuations (and bond yields) should impact your asset allocation decision, and you should review your plan on an ongoing basis because valuations and yields change over time. Having said that, I want to be clear that, with rare exceptions (to be discussed later), stock market valuation metrics (such as price-to-earnings (P/E) ratio) shouldn’t be used to time the market.

In other words, a higher-than-average P/E ratio shouldn’t be treated as a signal to sell, despite what prominent market prognosticators such as Jeremy Grantham and John Hussman do. Nor should a lower-than-average P/E ratio be treated as a signal to buy.

High P/Es Don’t Justify Market Timing

Even though a high P/E ratio—at least within a very broad range—is a good indicator that future returns are likely to be below average, there should still be an equity risk premium. Stocks should still be expected to outperform riskless investments, such as Treasury bills.

The exception to this dichotomy would be when there is a very clear bubble, like the one we had with growth stocks in the late 1990s. There was no way to justify the Nasdaq-100’s earnings yield (or E/P ratio) of about 1 percent, nor the S&P 500’s earnings yield of about 3 percent, when Treasury inflation-protected securities (TIPS) were yielding around 4 percent.

But even then, if you sold your position, at what level do you buy back in? Market timing is a very slippery and dangerous slope, which is why so few succeed and why Warren Buffett advises against it.

However, we do know that high valuations mean that future expected returns are low, and vice versa. Thus, valuations do impact the need to take risk. And the same is true of bond yields.



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