Personal note: Sorry for the long delay from posting. I had a death in the family this summer, a big overseas family wedding, and I’ve been working on getting my newsletter released, which I’ll announce in a later post. Now, I’m back.
I was thinking this morning that with the increasing talk of market valuation, bubbles, etc. it would be a good time to revisit my post on TAA vs buy and hold in overvalued markets from 5 months ago. Read that post for a background on the analysis I did below. Since we’re at a new level in CAPE ratio, above 30 now, let’s re-run the analysis I did in my earlier post but do it now for years where the market has been above a CAPE of 30.
Here are results of forward returns from markets where the CAPE was above 30 compared to one TAA strategy (Antonacci’s GEM). For more information on TAA see my Portfolios page or AllocateSmartly. I would expect results would be similar for most TAA strategies.
If you compare the table above with the one in my previous post you’ll see that the spread between the SP500 average forward returns and the GEM average forward returns increases at higher CAPE levels. This true for all holding periods. The sample size is not huge – 6 out of the last 88 years have had CAPE levels of 30. Note that ALL returns are lower, even for the TAA strategy, from higher valuations but the drop for buy and hold is worse than for TAA.
So, I wouldn’t change my summary from the earlier post much, except maybe that the odds are higher now.
In summary, a TAA strategy is a powerful alternative to buy and hold, especially in periods of high market valuation. While returns for TAA in periods of high valuation are also lower than their long term averages they are significantly better than buy and hold and maybe more importantly with much lower drawdowns. Just like with any strategy that is different it also comes with its own set of challenges but the odds are that it will have better outcomes going forward.
Of course, that doesn’t mean the market can’t go to higher valuations. If you want to see a case of valuation really run amok just look at the Japanese bull market that ended in the late 1980s. Michael Batnick had a great post on the Japan bubble a few months ago that is well worth your time and bookmarking. Here’s the craziness chart. It’s one thing to say the market can stay irrational a lot longer than you can stay solvent but it’s quite another to see a real historical example staring at you.
Valuations in Japan hit a peak CAPE level of 94! After the Japanese market hit a CAPE of 40 it continued on and rose another 3x! It went up 67% after hitting a CAPE of 80! Crazy. This is obviously an extreme example but well worth remembering.
In short, considering where we are, where we’ve come from, what several historical examples illustrate, TAA is a reasonable portfolio approach in today’s overvalued markets.
15 Comments
Marty Cohen · October 1, 2017 at 9:36 am
I am wondering for those of us who either don’t have time or who worry that our elder spouses won’t have interest , if there is some mutual fund or ETF that incorporates a TAA strategy that looks appealing? Thanks in advance. Marty
Peter Wang · October 1, 2017 at 10:07 am
Marty, the closest ETF I’ve found is VMOT from AlphaArchitect.com, trouble is it’s very small and brand new. If it does well through the next major downturn, it will become a candidate for me. Also the big companies will likely start copying it if it’s a hit. AlphaArchitect will also run your money with Antonacci’s “Enhanced” GEM for 0.90% per year. I don’t want to be trading when I’m 80, that sounds risky, I want to hire someone to do it for me.
paul.novell@gmail.com · October 1, 2017 at 10:25 am
VMOT is not really what I would call a TAA ETF. What is needed is an ETF or a robo that implements existing TAA strategies cheaply.
I consider VMOT more of a quant stock strategy ETF. An expensive one at that. Maybe as it grows and gets cheaper it will be a good candidate to implement quant stock strategies.
Paul
paul.novell@gmail.com · October 1, 2017 at 10:19 am
Marty, you raise some big important issues. Unfortunately there are no great automatic TAA options out there. None that I have found appealing anyway.
Paul
paul.novell@gmail.com · October 1, 2017 at 10:40 am
The closest solution out there is the robo advisor solution from the guys at Resolve. They use their own TAA strategies only. $150K minimum. 0.95% in fees all in. Not bad. Not perfect.
Paul
Peter Wang · October 1, 2017 at 9:43 am
The CAPE scares me. It could get worse, indeed. Why not 40 again? Why not 60? I’m currently sitting at 60% GEM, 20% bonds, 10% cash, 10% tangible assets.
paul.novell@gmail.com · October 1, 2017 at 10:21 am
Yep. Exactly. But it sounds like you have a solid plan so no reason to be scared. You’ll participate in the upside and are protected on the downside.
Paul
Fred · October 2, 2017 at 4:46 pm
No love for GMOM?
paul.novell@gmail.com · October 3, 2017 at 5:15 am
Not really. I think it casts too wide a net which makes performance suffer. And for 0.8% in fees. No thanks.
The Resolve solution is better.
Paul
Peter Wang · October 3, 2017 at 5:17 am
Well… GMOM… great idea, everyone loves Meb’s classic paper about trendfollowing the Ivy Portfolio, but I think DIY trendfollowing the Ivy Portfolio has done better than GMOM. He throws his own ETFs into GMOM, some of which stink to high heaven. It’s only 3 years old, ask after the coming correction.
paul.novell@gmail.com · October 3, 2017 at 7:22 am
Agree. Needs more time at the minimum. FWIW, when I have tried implement a GMOM approach it always produced lower results than simpler solutions.
But the original question was a search for canned solutions for people who don’t want to do DIY quant. Nothing great out there for that.
Paul
Peter · October 3, 2017 at 3:35 pm
Hi Paul, given how great Antonacci’s GEM model is, I have been thinking of implementing a leveraged version of it. Antonacci, even proposes a 1.3x leveraged version of GEM in his book. I feel like it could be most cheaply accomplished using futures. Unfortunately, there is no futures contract for an international index other than FEZ, which tracks European stocks. And, there is no aggregate bond futures contract, but I’m wondering if I could use the 5 yr Treasury futures contract as a proxy for that. If you take a look here: http://stockcharts.com/freecharts/perf.php?SPY,FEZ,VEU,IEI,AGG, you’ll notice that the 5 yr Treasury future farily closely mirrors the AGG bond ETF. The FEZ ETF does a not-so-great job as a proxy of the VEU international ETF, but I would say it’s close enough. Do you think it makes sense to use these three futures contracts to run a leveraged version of GEM? I am very comfortable with futures and all their intricacies, such as the need for rolling and being careful of leverage. I appreciate any thoughts you may have. Thanks.
paul.novell@gmail.com · October 4, 2017 at 4:33 am
Yes, it could work. You can trade futures on European markets, even the MSCI world index I believe, through IB.
I would probably use the 10 yr futures contract but whichever.
The strategy, of course, would have higher returns but higher vol and drawdowns.
Paul
Scott · October 3, 2017 at 4:01 pm
Thank you Paul, that is very interesting.
Is there a way to incorporate interest rates, given that interest rates set the asset pricing environment? Perhaps comparing the 10 year government bond yield to the 10 year cyclically adjusted earnings yield (1/CAPE) during these high-CAPE instances would lead to an interesting result.
paul.novell@gmail.com · October 4, 2017 at 4:24 am
There are ways to do that but in my experience it is not worth it. Strategies that use valuation based timing signals suck. Most TAA strategies use some form of momentum or trend following which is far more effective and powerful.
Paul
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