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I am a conservative investor with an asset mix of around 50% bonds/cash and 50% stock via large index ETFs. Recently I've been thinking about settling down on a non-emotional way to decide whether additional investments are split evenly, go to the bond side, or the stock side of the portfolio.

I am starting to settle on using the P/E ratio as the deciding factor since I am trying to avoid speculating on the market but want to be in it for the long haul. My problem is deciding on what P/E level is good vs. bad for additional investments. The P/E ratio of the S&P 500 is around 14 and the Russell 2000 around 18 according to yahoo. These are well below the level of 20 that Shiller thinks is the cutoff.

Has anyone had experience using the P/E ratio for investment decisions? How do dividends figure into the equation? Should the P/E ratio of the index be calculated as an average or a market value weighted average?

Sorry for being a bit open-ended on the question. I would be happy to share my portfolio breakdown if that helps as well.

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P/E alone would not work very well. See for example http://www.hussmanfunds.com/html/peak2pk.htm and http://www.hussmanfunds.com/rsi/profitmargins.htm (in short, P/E is affected too much by cyclical changes in profit margins, or you might say: booms inflate the E beyond sustainable levels, thus making the P/E look more favorable than it is). Here's a random blog post that points to Schiller's normalized earnings measure: http://seekingalpha.com/article/247257-s-p-500-is-expensive-using-normalized-earnings

I think even Price to Sales is supposed to work better than P/E for predicting 10-year returns on a broad index, because it effectively normalizes the margins. (Normalized valuation explains the variance in 10-year returns better than the variance in 1-year returns, I think I've read; you can't rely on things "reverting to mean" in only 1 year.)

Another issue with P/E is that E is more subject to weird accounting effects than for example revenues. For example whether stock compensation is expensed or one-time write-offs are included or whatever can mean you end up with an economically strange earnings number.

btw, a simple way to do what you describe here would be to put a chunk of money into funds that vary equity exposure.

For example John Hussman's fund has an elaborate model that he uses to decide when to hedge. Say you invest 40% bonds, 40% stocks, and 20% in Hussman Strategic Growth. When Hussman fully hedges his fund, you would effectively have 40% in stocks; and when he fully unhedges it, you would have 60% in stocks. This isn't quite the whole story; he also tries to pick up some gains through stock picking, so when fully hedged the fund isn't quite equivalent to cash, more like a market-neutral fund.

(For Hussman Funds in particular, he's considered stocks to be overvalued for most of the last 15 years, and the fund is almost always fully hedged, so you'd want to be comfortable with that.)

There are other funds out there doing similar stuff. There are certainly funds that vary equity exposure though most not as dramatically as the Hussman fund. Some possibilities might be PIMCO All-Asset All-Authority, PIMCO Multi-Asset, perhaps. Or just some value-oriented funds with willingness to deviate from benchmarks.

Definitely read the prospectus on all these and research other options, I just thought it would be helpful to mention a couple of specific examples.

If you wanted to stick to managing ETFs yourself, Morningstar's premium service has an interesting feature where they take the by-hand bottom-up analysis of all the stocks in an ETF, and use that to calculate an over- or under-valuation ratio for the ETF.

I don't know if the Morningstar bottom-up stuff necessarily works; I'm sure they make the "pro" case on their site. On the "con" side, in the financial crisis bubble bursting, they cut their valuation on many companies and they had a high valuation on a lot of the financials that blew up. While I haven't run any stats and don't have the data, in several specific cases it looked like their bottom-up analysis ended up assuming too-high profit margins would continue. Broad-brush normalized valuation measures avoided that mistake by ignoring the details of all the individual companies and assuming the whole index had to revert to mean.

If you're rich, I think you can hire GMO to do a varied-equity-exposure strategy for you (http://www.gmo.com/America/).

You could also look at the "fundamental indexing" ETFs that weight by dividends or P/E or other measures of value, rather than by market cap.

The bottom line is, there are lots of ways to do tactical asset allocation. It seems complex enough that I'm not sure it's something you'd want to manage yourself.

There are also a lot of managers doing this that I personally am not comfortable with because they don't seem to have a discipline or method that they explain well enough, or they don't seem to do enough backtesting and math, or they rely on macroeconomic forecasts that probably aren't reliable, or whatever.

All of these tactical allocation strategies are flavors of active management. I'm most comfortable with active management when it has a fairly objective, testable, and logical discipline to it, such as Graham&Buffett style value investing, Hussman's statistical methods, or whatever it is.

Many people will argue that all active management is bad and there's no way to distinguish among any of it. I am not in that camp, but I do think a lot of active managers are bad, and that it's pretty hard to distinguish among them, and I think active management is more likely to help with risk control than it is to help with beating the market.

Still you should know (and probably already do know, but I'll note for other readers) that there's a strong argument smart people make that you're best off avoiding this whole line of tactical-allocation thinking and just sticking to the pure cap-based index funds.

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P/E is a useful tool for evaluating the price of a company, but only in comparison to companies in similar industries, especially for industries with well-defined cash flows.

For example, if you compared Consolidated Edison (NYSE:ED) to Hawaiian Electric (NYSE:HE), you'll notice that HE has a significantly higher PE. All things being equal, that means that HE may be overpriced in comparison to ED. As an investor, you need to investigate further to determine whether that is true. HE is unique in that it is a utility that also operates a bank, so you need to take that into account.

You need to think about what your goal is when you say that you are a "conservative" investor and look at the big picture, not a magic number. If conservative to you means capital preservation, you need to ensure that you are in investments that are diversified and appropriate. Given the interest rate situation in 2011, that means your bonds holding need to be in short-duration, high-quality securities. Equities should be weighted towards large cap, with smaller holdings of international or commodity-associated funds. Consider a target-date or blended fund like one of the Vanguard "Life Strategy" funds.

  • Since I invest mainly via large index ETFs, even for bonds, would the P/E number have any significance at all so to the decision of whether an extra investment goes to the bond or stock side? – Gennadiy Apr 11 '11 at 20:39
  • It might be worth clarifying which P/E you mean (forward estimates, trailing 12 months, operating earnings only, normalized for business cycle, etc.) and also your time horizon (are you trying to make the right stocks/bonds call looking back from next year or from next decade). – Havoc P Apr 11 '11 at 22:01
  • I have a buy and hold portfolio with additional investments every month or two.The time horizon is retirement or if anything crucial comes up, 10 years. The P/E ratio I am looking at will probably be the 12 month trailing, not forward, or maybe the Price over 10 year trailing, since that should be available for the large indexes I use for stock vehicles. The stock portion consists of: IWV, IJH, IWM, EFA, SCZ, EEM. The Bond portion consists of: AGG, EMB. I also keep a cash buffer of 20% for emergency purchases (this saved me in 08-09). – Gennadiy Apr 12 '11 at 4:07
  • my .02 is that the margins-normalized P/E (like price to peak earnings or 10 year trailing Schiller ratio multpl.com) or perhaps price to sales would be the way to go on a retirement horizon. 1 year or current P/E has too much cyclical noise. – Havoc P Apr 15 '11 at 14:33

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