My question. I've been reading about Valuation-Informed Indexing (VII). What is your reaction? Would you recommend this strategy? What are its potential strengths/weaknesses?
Background. For those who don't want to click through, the proposal seems to be something like this. You use an index, and adjust the ratio of stocks/bond based upon whether a simple calculation estimates that the market is overpriced or underpriced. In particular, calculate the P/E10 (the price-to-earnings ratio for the entire index, with earnings averaged over the past ten years).
- If P/E10 is below 12, invest in 90% stocks and 10% bonds.
- If P/E10 is in the range 12-21, invest in 60% stocks and 40% bonds.
- If P/E10 is above 21, invest in 30% stocks and 70% bonds.
Analysis. I saw an analysis which looked at a related strategy: instead of 12 and 21, analyze the historical data for P/E10 ratios up until now to calculate the top 25% percentile and bottom 25% percentile for historical P/E10 ratios. That analysis ran some simulations over rolling 30-year periods and compared to buy-and-hold with a fixed mix of 60% stocks and 40% bonds. Apparently, in the simulation the VII strategy beat buy-and-hold for 102 out of 110 of the rolling 30-year periods.
(My impression was that rolling periods is statistically a bit dubious, because the 110 data points are highly correlated: you only have something like 110/30 = 4 independent data points, not 110 independent data points. I don't know whether that's right.)
(Footnote: Here is some analysis looking at whether P/E10 can help predict whether bonds will beat stocks.)
Personally, I'm not sure whether to buy the VII proposal. It sounds like long-term market timing: trying to do a better job than the rest of the market at predicting, based upon a simple formula, whether the market is over-priced or under-priced. Is it plausible that this could work? I know short-term market timing has gotten a bad rap; do the reasons for avoiding short-term market timing apply to the VII proposal as well? Does the VII proposal assume the Efficient Market Hypothesis is wrong, and is that a reason to be skeptical of the VII proposal?
Summary. In short, does anyone have any reactions to, or analysis of, this proposal? Do you find the arguments and evidence credible aand convincing? Why or why not? What do you see as the strengths or weaknesses of the proposal or the evidence supporting it? Thanks in advance!