Swedroe: Valuation Metrics In Perspective

November 11, 2015

Testing TAA

To test the concept behind TAA, Estrada used several different tactical strategies and compared their performance to a 60 percent equity/40 percent bond portfolio, with 5 percent rebalancing bands (meaning an investor would buy stocks if the equity allocation fell below 55 percent and sell them if the allocation rose above 65 percent). Rebalancing would be done annually. Estrada’s sample consisted of monthly total return indexes for stocks and bonds between September 1899 and December 2014. Stocks in the sample were represented by the S&P 500 and bonds by 90-day U.S. Treasury bills.

The TAA valuation-based strategies Estrada considered in his analysis seek to implement an aggressive portfolio when stocks are cheap, and a conservative one when stocks are expensive. When starting from the benchmark 60/40 allocation, an aggressive portfolio increases its allocation to stocks by 20 percentage points (to 80 percent) while the conservative portfolio reduces its allocation to stocks by 20 percentage points (to 40 percent).

At the close of each year, stocks are determined to be cheap (expensive) if a multiple is more than one standard deviation below (above) its long-term mean, and fairly valued if the multiple ends up within one standard deviation of its long-term mean. When stocks are fairly valued (as just defined) at the end of each year, the same tolerance bands used for the benchmark 60/40 portfolio are then applied to the valuation-based portfolios.

Estrada also looked at a tactical strategy that required a two-standard-deviation event, as well as a more aggressive shift in allocations. Instead of a 20 percentage point shift in equity allocations, he used a 30 percentage point shift (allocations could move from 60/40 to 90/10 or 30/70).

The Evidence

Estrada found that when employing the 20 percentage point shift and one-standard-deviation rules, even before considering trading costs and taxes, results for the static 60/40 portfolio, with rebalancing, were virtually the same as for the tactical strategies (whether they used D/P, E/P or the CAPE 10). Not only were their returns virtually identical, so were their standard deviations. All the portfolios produced returns of about 8.1 percent with a standard deviation of roughly 11.0.

However, the 60/40 portfolio produced by far the fewest transactions. It required 37 rebalancing events, while the other three portfolios needed almost twice as many (from 69 to 71). The results were similar when using the more aggressive, 30 percentage point shift rule.

When Estrada looked at the 20 percentage point shift and two-standard-deviation rules, he again found similar results. In this case, the 60/40 benchmark portfolio produced the highest return (8.1 percent versus between 7.9 percent and 8.0 percent for the tactical strategies), but did so with slightly higher volatility (11.0 versus 10.6 for the tactical strategies).

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