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Stock Valuations - Do They Matter? Part 2: The "What Goes Up Must Come Down" Theory

| September 10, 2014
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If you have not yet read Part 1 of this series (The Shiller PE/10 Ratio), please take a moment to do so before continuing....failure to do so will leave you unfulfilled and confused!

If you have read the Round Hill Rant consistently, you know that we have spent much time discussing the importance of removing emotion from investment decisions.  Our last rant then discussed the merits of using valuation metrics as reasoning to adjust asset allocations in a disciplined manner.  Today we will combine the two topics - comparing disciplined tactical allocation based on specific valuation metrics vs. tactical allocation based on how we "feel about" current valuations.

I am sure that many of you had never heard of a Shiller PE Ratio before our last rant.  At the same time, I bet most of you at some point in time have found yourself thinking "I really don't trust the market right now after it's run up so much."  That thought process is not based on any sort of statistical metric - it's much more emotional and based on what I call the "What Goes Up Must Come Down (and vice versa)" theory.  More common sense (and emotion) and less statistical mumbo jumbo.  In my experience, the average investor is much more likely to have experienced and acted on this type of thought process rather than a disciplined strategy based on actual metrics - so I thought it interesting and useful to examine it's utility...

Like our last entry, I am saddened to report that we are prohibited from sharing the numerical data backing our research.  Again, we were left to decide whether to scrap the whole thing or discuss our findings in generalities.  We ultimately came to the same conclusion - the importance and relevance of the topic outweighed our lack of flexibility in reporting the actual numbers.  So with that in mind, we ask for your patience and remind you that NONE of what we are discussing here should be taken as ANY representation of expected returns or performance.

Part 1 of this series discussed what had happened when we adjusted a target allocation of 50% stocks (S&P 500 index) and 50% bonds (10 year treasury, constant maturity total returns) - adding equity exposure when equity valuations were depressed and reducing exposure when they were elevated.  Our research today studied the same type of theory - but rather than using the Shiller PE as our valuation metric, our allocation adjustments were based solely on previous year market returns.  Following years of "above average" returns in the S&P (top quartile historically), we reduced equity exposure by 20%.  We added equity exposure by the same percentage following years where the market had "below average" (bottom quartile) returns - always returning to the target allocation following years of "normal" (neither top or bottom quartile) market returns (yes, I do realize how infantile this summary sounds when not accompanied by actual numbers - but my hands are tied here, so cut me some slack!!).  I called this test our "What Goes Up Must Come Down" theory.  We conducted our research over the exact same time periods for consistency - beginning in 1963 (50 years), 1973 (immediately preceding major correction), and 1993 (immediately preceding strong market gains). 

Have to admit, I was surprised with the results.  Compared against the research we did using the Shiller PE Ratio as our metric, our "What Goes Up Must Come Down" study produced meaningfully LOWER actual and risk-adjusted returns for each of the periods tested.  In fact, even the static allocation achieved higher returns along with lower volatility when compared to our "common sense" model.  Looking at both together, it seemed that valuation did indeed seem to matter - but we needed to pay close attention to HOW we were measuring valuations.  Failure to do so, at least in our research, not only lacked benefit - it actually proved harmful.

Both of our tests were in essence doing the same thing - buying when stocks were "undervalued" and selling when they were "overvalued" - so how do we explain the difference in results?  In my opinion, the answer is both simple and extremely important - "emotion" vs. "discipline".  Our "What Goes Up Must Come Down" theory is very much emotion based - our decisions are based on how we "FEEL" about current valuations based on recent returns.  Yes, there was discipline and numerical triggers involved - but those triggers were simply the result of prior-year performance - and that prior year performance might make us "FEEL" like stocks are over or under valued.  Our research using the Shiller PE in a disciplined fashion - in addition to utilizing Nobel Prize winning valuation metrics - has no emotional component to it.

I began my career in 1994 - in the midst of arguably the most emotion-driven decade in stock market history.  From my experience in talking with clients, there are MANY more investors who make investment decisions based on emotion rather than discipline.  Worse yet, many (maybe most) investors let emotion cause them to do the OPPOSITE of what we tested here - adding stocks AFTER substantial market gains and removing stocks (often entirely) AFTER vicious market corrections.  I don't need to do any research to tell you how that story ends......very badly!  Please remember, from a psychological / emotional standpoint, it is very difficult to take profits after large gains, and even more difficult to buy stocks while markets are collapsing around us.  Yet this is exactly what we should be considering - buying low and selling high - not the other way around! 

Just when I thought that there could not possibly be another disclosure to add, yet another new one has been requested.  And since the list of disclosures now takes about as much space as the rest of this writing, I have decided to list them below......     

As always and most important - to all of our clients - we thank you for your continued trust and confidence in Round Hill Wealth Management.

Thanks for listening -

Doug

IMPORTANT DISCLOSURES

The opinions expressed in this rant are solely my own, are not intended to provide specific advice or recommendations to any individual, and do not necessarily reflect those of LPL Financial.

Investing involves risk - including potential loss of principal.

Past performance (insinuated in this case) is no guarantee of future returns.

Please note that indices discussed in this rant are unmanaged and may not be invested into directly.

Tactical allocation may involve more frequent buying and selling of assets, and will tend to generate higher transaction costs.  Investors should consider the tax consequences of moving positions more frequently.

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