Re-balance Cycle Reminder All MyPlanIQ’s newsletters are archived here.

Regular AAC (Asset Allocation Composite), SAA and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Monday March 2, 2020.

Please note: As of today, we now officially phase out our old rebalance calendar for both SAA and TAA. They are now always rebalanced on the first trading day of a month. 

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Long Term Stock Valuation Based Investment Strategies

By practically any sensible long term stock valuation metrics (for example, those listed on our Market Indicators page), current stock market valuation is extremely overvalued. The problem is what to do with it.

One obvious way is that when stocks are very overvalued, you switch to cash and then wait patiently until they become undervalued and get back in. This is the typical ‘market timing’ method. Of course, it has been thoroughly discredited in media.

In this newsletter, we dive in a bit deeper to analyze this issue.

Market timing

Market timing can mean different things to different people. In general, it has a bad rap as many have been tagged as ‘speculators’ or just ‘traders’. Outside of the Wall Street,  ‘traders’ are usually shunned away. It’s widely believed that market timing doesn’t work, at least for average investors.

Of course, a real investor should be someone who holds stocks or bonds (securities) which they view to be be able to deliver some reasonable good returns in certain future time frames. They can be either five, ten or as long as twenty years. For these investors, the tough problem is what to do when they view these securities are overvalued, especially very overvalued. 

Investors who pick individual stocks and invest, people like Warren Buffett, famed value stock fund managers (Sequoia, Dodge & Cox, Baupost, to name a few), are less sensitive to stock market valuation as a whole. For them, if the market is expensive, it becomes harder for them to find good bargains. In the situation where they can’t find new stocks to invest for their excessive cash, they might choose to hold cash until a new opportunity emerges. This is at least how a true value investor like Buffett or Seth Klarman would do.

For average investors, we have advocated that they can simply invest in some diversified, ultra low cost stock index funds such as S&P 500 (VOO or SPY). Fundamentally, when you invest in an index fund like SPY, you invest in a loosely passively managed conglomerate ‘business’. Fortunately, this ‘business’ is actually a very outstanding business: for example, this business never lost money in a single year and it has on average delivered more than 6% annual real earnings (over inflation) since 1871 (see  April 1, 2019: S&P 500 As A Business for more details). Even Warren Buffett uses S&P 500 index as Berkshire Hathaway’s performance benchmark and admits that it’s very hard to beat it.  In fact, studies have shown that these so called ‘index’ investors can do as well as or better than some of the best actively managed funds in a long term.

Unfortunately, for these index investors, when stock markets are overvalued, the choices are quite limited. For example, if you only use S&P 500 index fund or a total market index fund like Vanguard’s VTI to invest in US stocks, right now, the situation is that either you have to stick to this overvalued security (i.e. SPY or VTI) or switch to other safer securities such as cash. If you do the latter, you run into the risk of being a market timer who is said to fail eventually.

Long term valuation metrics based market timing strategies

Now if you use a simple market timing strategy that invests in cash when stocks are overvalued, your returns will suffer greatly. For example, in the following table, P Warren Buffett Total Stock Market Valuation to GNP Ratio SO SU Weekly Strategy switches to cash when Buffett’s favorite long term stock valuation metric (Stock Market Capitalization/Valuation to GNP Ratio) indicates it’s overvalued (in this portfolio, if the ratio is over 1.15, it switches to cash and if the ratio falls below 0.5, it buys SPY). This portfolio’s return has been dismal: 10 years’ AR (annualized return) 8% vs. VFINX (Vanguard S&P 500 index fund)’s 13.8% or 15 years’ 8.6% vs. VFINX’s 8.9% (much better for the 15 years).

On a closer look, this portfolio switched to cash since 2014! So it has earned 0.8% annually for the past 5 years! If you happen to be such an unlucky investor, you’ll understand how bad it’s been to see your portfolio sits there while stocks like S&P 500 have soared higher and higher for the last 5 plus years.

The following chart shows its returns since 2001:

So this confirms the popular claim that market timing doesn’t work!

However, if we look at a little bit more sophisticated portfolios that switch to a total return bond fund portfolio (see fixed income investment portfolios) instead of cash, things become interesting.

On Advanced Strategies page, we have been tracking the three long term stock valuation metric based timing portfolios for almost 10 years. The following table shows how they have performed (in addition to the above ‘simple’ timing portfolio):

Portfolio Performance Comparison (as of 2/21/2020):
Ticker/Portfolio Name YTD
Return**
1Yr AR 3Yr AR 5Yr AR 10Yr AR 15Yr AR
P Hussman Peak PE SO SU Market Timing Strategy WeeklyTotal Return Bond Funds As Cash 3.6% 24.1% 9.8% 7.2% 9.8% 10.6%
P Shiller Cyclically Adjusted PE 10 SO SU Stock Market Timing Strategy Weekly Total Return Bond Funds As Cash 3.6% 24.1% 9.8% 7.2% 10.2% 11.1%
P Warren Buffett Total Stock Market Valuation to GNP Ratio SO SU Weekly Strategy Total Return Bond Funds As Cash 3.2% 12.9% 6.5% 5.2% 10.4% 11.3%
P Warren Buffett Total Stock Market Valuation to GNP Ratio SO SU Weekly Strategy 0.1% 1.3% 1.2% 0.8% 8.0% 8.6%
VFINX (Vanguard 500 Index Investor) 3.6% 22.5% 14.2% 11.7% 13.8% 8.9%

These three portfolios all switch to P_46880 (Schwab Total Return Bond) instead of cash when markets are overvalued. In fact, for the past 10 years, for example, annualized return of P Warren Buffett Total Stock Market Valuation to GNP Ratio SO SU Weekly Strategy Total Return Bond Funds As Cash has been improved 10.4%, compared the simple one’s 5.3%!

These three portfolios not only thoroughly beat the buy and hold VFINX, they also incurred only 1/3 of maximum drawdown (loss)! See the details for more info.

Discussions

The above offers some interesting insights: instead of switching to cash, our total return bond portfolio has done a very reasonable job: since the end of 2014, for example, P_46880 (Schwab Total Return Bond) has returned annualized return 5.3% up to 2/21/2020, compared with cash’s subzero return. In other situations, it also delivered outsized gains. This is because for the past 5 plus years, such a fixed income bond portfolio can also take risk to invest in some risky bonds such as high yield corporate bonds or high yield municipal bonds. This actually has helped to boost returns greatly. The point is that fixed income investment is not necessarily boring or uninspiring as many view. In fact, for the past 15 years, this bond portfolio annualized return is 7.7%, better than 7.4% of VBINX (Vanguard moderate allocation fund)!

These portfolios continue to defy popular simple claims. They also show that there is a path for a ‘real’ (value) index fund investor: you don’t need to take excessive risk to outperform in a long term. This is especially compelling considering right now, stock valuations are at historically high levels. This also fits well to an ultra conservative income investor (retirees, for example).

Market overview

Stocks are finally shaken up by the fear of coronavirus outbreak: global stocks took a dive after more infected cases were reported worldwide. Earnings wise, based on Factset, up to last Friday (2/21/2020), with 87% of the companies in the S&P 500 reporting actual results, the blended earnings growth rate for S&P 500 is 0.9%, continued to be better than previous weeks’. Whether the coronavirus outbreak may become a worldwide pandemic that will wreak havoc world economy is still unknown. Markets are just taking some short term guesses and can sway both ways. 

Regardless, this is an overly extended and very overvalued market. We thus call for staying the course and adopting a more tactical strategy.

For more detailed asset trend scores, please refer to 360° Market Overview.

In terms of investments, even after the recent retreat, U.S. stock valuation is still at a historically high level and a bigger correction is still waiting to happen. It is thus not a good time to take excessive risk. However, we remain optimistic about U.S. economy in the long term and believe much better investment opportunities will arise in the future.

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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