[Editor's Note: This is another in the popular Pro/Con series. My debate opponent,  Liaquat “Lee” Sheikh, a registered investment advisor, sent me a guest post which listed four methods to increase the risk-adjusted returns of your portfolio. I heartily agreed with two of them- using international stocks and diversifying the portfolio across numerous asset classes. But they've been discussed so many times here, I didn't think they were particularly useful to publish. However, his other two ideas are far more controversial, and thus appropriate for a Pro/Con Series. He will be presenting the Pro side to using a valuation-based tactical asset allocation strategy and I will be presenting the Con side.]
Lee Sheikh

Lee Sheikh


Valuation-Based Tactical Asset Allocation Increases Risk-Adjusted Returns

The valuation level of the stock market is critical to the future performance of an investment portfolio. Investors should concentrate their investment portfolio in global equity markets which are currently trading at lower valuation levels. These equity markets offer greater future returns

There are many variables which investors consider when determining the optimal asset allocation of their own individual portfolio. For example, two major factors which investors consider is their own personal risk tolerance and the time horizon to achieving their major financial goals (such as funding either their child's college education or their own retirement). However, a third criteria which is critical in determining the success of an investor's portfolios, but which few investors consider, is the current valuation of the stock market. Academic research has shown that market valuation has a profound impact on future equity returns. The chart below from Robert Shiller's book Irrational Exuberance demonstrates this point.

Robert Shiller analyzed the relationship between the P/E (10 year) ratio of the market and the corresponding future 20 year annualized market returns. The P/E (10 year) ratio uses the trailing 10 year real per share earnings of the market rather than the standard price to earnings ratio which only considers the trailing 1 year earnings of the market. Shiller believed that this approach was superior because it accounts for any cyclical variation in earnings resulting from the business cycle. As you can see from the chart above, markets which have been at a lower valuation based on their P/E (10 year) ratio have experienced higher future 20 year annualized returns and markets which have been at a higher valuation level based on their P/E (10 year) ratio have experienced lower future 20 year annualized returns. What is also interesting to note is that the negative correlation between market valuation and future investor returns was very consistent in all time periods which Robert Shiller studied from 1890-1985. This clearly demonstrates that market valuation plays an important in an investor's portfolio asset allocation. When U.S. equity markets are at higher valuations investors should reduce their equity allocations.

How this translates to the current market valuation:

As the chart below shows the current P/E (10 year) ratio for the U.S. stock market is 26.23, well above its historical average of 16.55. Historically, the market has not been able to sustain market valuations that are this high. The previous instances in which market valuations were this high were the early 1900s, late 1920s, late 1960s, and late 1990s. By examining a historical chart of the Dow Jones Industrial Average, one can clearly see that there were deep market recessions after all previous instances in which market valuations were at the current levels. Investors better hope that the earnings of companies in the S&P 500 are able to catch up with price move the S&P 500 has experienced over the last couple of years or the current stock market rally will be in jeopardy.

I occasionally use a tool/calculator that uses the current valuation of the stock market along with historical market return data to project future returns. The chart below is a projection of what future market returns will be based on the current valuation level of the market (P/E (10 year) ratio of 26.23).

The most likely return scenarios for investors in the U.S. equity market for the next 10 and 20 year periods are not very promising. The market is most likely to return 1.29% for the next 10 years and 2.71% for the next 20 years. These returns are well below the historical real return for the U.S. equity market which has historically hovered between 6.5%-7.0%.

Investors will need to adjust their portfolios to overcome these meager returns. Fortunately, U.S. investors have a world of investment opportunities available to them thanks to exchange traded funds (ETFs). ETFs are index based investments which are available in virtually every investible asset class including U.S. stocks, foreign developed market stocks, emerging market stocks, U.S. government bonds, high yield bonds, foreign bonds, commodities, etc. There are a number of foreign markets which are at a much more attractive valuation level compared to the U.S. This is largely due to the fact that these markets have not rallied as strongly as the U.S. market has rallied in the past 5 years. The following table shows some of the major foreign market ETFs which are currently trading at below average valuation levels relative to their historical averages based on Morningstar data.

Foreign Market

ETF which Tracks

this Market

Current P/E Valuation







South Korea















United Kingdom



Trend-Following Can Further Enhance Returns

Academic research has shown that tactical asset allocation can improve an investment portfolio's returns and reduce its volatility over time. Tactical asset allocation is the practice of adjusting a portfolio's asset allocation based on the current market trend. One of the most prominent researchers who has studied the benefits of tactical asset allocation is Sean Hanlon of Hanlon Investment Management. Mr. Hanlon has conducted many studies on the risk/return benefits of employing a tactical asset allocation strategy. In one of his studies, Hanlon compared the risk and return of an S&P 500 buy and hold portfolio to that of an S&P 500 tactical asset allocation portfolio between the time period of 1988-2011. The buy and hold portfolio is fully invested in the S&P 500 during the entire time period.

The tactical asset allocation portfolio moves between the S&P 500 Index and a money market fund based on a 50 day/200 day moving average crossover. The tactical portfolio is fully invested in the S&P 500 when the 50 day moving average is above the 200 day moving average (an indication that the market is in an uptrend). The tactical portfolio is fully invested in the money market fund when the 50 day moving average is below the 200 day moving average  (an indication that the the market is currently in a downtrend). The chart below shows a comparison of the risk and return of the Buy and Hold Portfolio vs the Tactical Asset Allocation 50 day/200 day Moving Average Crossover Portfolio.

The outperformance of the tactical asset allocation portfolio over this time period demonstrates the importance of avoiding large investment losses. A significant part of the reason why the tactical portfolio outperformed the Buy and Hold Portfolio is because of the difference in maximum drawdown. The Buy and Hold Portfolio declined 55% during the 2008 recession. A portfolio that has declined 55% needs a 122.22% gain to recover its portfolio value.


The Past Is Not The Future

There is little doubt that buying any investment when it is “cheap” will lead to better returns than buying it when it is “expensive.” You don't need an academic study to prove that. The problems come in when you assume the future will be like the past. For example, let's consider an investor who decides to invest using the PE10 concept advocated by my opponent. Let's say he wants to buy stocks only when the PE10 is under 10. According to the chart my opponent has published, the last time that happened was 30 years ago. At this point, you might want to ask yourself what the stock market has returned for stocks purchased 30, 25, 20, 15, 10, and 5 years ago. Moneychimp has a handy calculator you can use to determine this. Here's a nice table I made from the data:

5 17.99%
10 7.36%
15 4.63%
20 9.22%
25 10.28%
30 11.14%

So what can we determine from this? Well, if you had decided to not invest that money 25 years ago, you would have missed out on 25 years of double digit returns. In fact, even the 2008 crash would not have made stocks attractive enough to buy under this system, even if you used a PE10 of 15 instead of 10! It didn't take a genius to see that stocks were on sale in Fall 2008 and Spring 2009. But looking for a historically low PE10 wouldn't have helped you recognize that. Your pessimism would have caused you to miss out on 5 years of 18% annualized returns!

The magic prediction chart/tool used above also assumes money is invested at a single point in time, not invested each month or year as the investor goes along. These periodic investments allow an investor to achieve a higher return than would otherwise be expected, by purchasing more shares when prices are low and fewer when prices are higher. But if the chart is right, and all the markets return over my investment career is 5-6%, then you've got to ask yourself, what are the alternatives? Cash pays less than 1%. Bonds yields are in the 2% range. Inflation is currently around 2%. 5-6% isn't looking too bad in comparison. But if you really think returns will be this low, you may wish to consider other alternatives. Frankly, I don't understand why anyone would buy stocks if they only expected a 2% real return. It's pretty darn easy to go buy an investment property with a Cap Rate of 5 or 6. Add that to appreciation and maybe a boost from some leverage and it'll leave a 5-6% return from stocks in the dust.

The table posted by my opponent suggests that buying ETFs in markets with low PEs will lead to higher returns. But perhaps you ought to take a look at what the PEs were in the past in those same markets and compare what the following returns were. You may find the correlation to be not nearly as high as you might think. Sometimes PEs are low for a reason. Consider Russia, for instance. They have a habit of nationalizing private companies and are well-known for serious corruption. Don't you think an investor ought to demand a lower PE compared to a company in the US, with its history of free markets and more reasonable regulation?

It's fine to pay attention to valuations, knowing that your returns will probably be lower when valuations are high and vice versa. But should you really DO something drastic about it? No. Following a written investing plan detailing a static asset allocation appropriate for you is far more likely to lead you to success.

Tactical Asset Allocation Is Too Good To Be True

Technical analysis and market timing are much maligned throughout the financial world for good reason. Jack Bogle said the following about market timing:

After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know of anybody who knows anybody who has done it successfully and consistently.
Regarding tactical asset allocation he said this:
If rational forecasts indicate that one asset class offers a considerably better investment opportunity than another, you might shift a modest percentage of your assets from the class judged less attractive to the class judged more attractive. This policy is referred to as tactical asset allocation. It is an opportunistic, transitory, aggressive policy that – if skill, insight, and luck are with you – may result in marginally better long-term returns than either a fixed-ratio approach or benign neglect.
Two men who have studied technical analysis more recently had this to say about it:

“The evidence suggests that technical analysis by itself is not a good predictor of future returns.”
Singal (2004)

“There have been long periods in the past when trading rules would have provided valuable information about future prices. However, their value has not been demonstrated in recent years.”
Taylor (2005)

Let's consider some mutual funds who have attempted this “tactical asset allocation.” Jason Zweig notes a study from Morningstar that looked at 42 Tactical Mutual Funds and found they trailed a simple 60/40 buy and hold benchmark by 5 percentage points a year, and that's not even including the additional taxes inherent in jumping around from one asset class to another. Even Vanguard's ultra-low cost asset allocation fund eventually folded with a terrible record. Rick Ferri has also written extensively on the subject. I'll tell you one thing I've learned about investing. There are only a few “good guys” in a sea of “bad guys.” When three of the good guys all say something isn't a very good idea, it's usually a good idea to listen. Even Jack Bogle who has mentioned tactical asset allocation, emphasizes the importance of keeping any portfolio changes very small and realizing that a lot of it comes down to luck.

Now, neither an appeal to authorities, nor an ad hominem attack on Sean Hanlon (you're not really surprised his “studies” advocate the exact approach his firm takes when managing money) are particularly strong arguments. So let's consider a few logical reasons why trend-following isn't such a good idea.

1) If you're going to follow trends, you actually have to follow the market or hire someone to do so. That requires time or money. They're really the same thing. On the other hand, a buy and hold portfolio takes minutes a year to manage and never requires you to follow anything. If market-timers also added in the cost of their time to follow the market, it would affect their returns significantly, especially if those market-timers are highly-paid professionals like physicians.

2) Market-timing requires buying and selling. The fewer times you enter the Wall Street Casino, the less often the house (and the government) gets its cut. Ongoing commissions, spreads, and taxes are very real and reduce returns significantly. Time in the market is far more important than timing the market. Purchase shares of profitable businesses and share in their profits rather than speculating repeatedly on what their share prices are going to do.

3) Whipsawing is the trend-followers enemy. Trend following, by definition, causes you to sell below the peak and buy above the trough. In a flat or particularly volatile market, a trend follower can find himself buying high and selling low, over and over again, incurring transaction costs each time. These whipsaws gradually erode any benefit seen in longer trends.

4) Trend-following requires even more discipline than buy and holding. If trend-following works, it requires iron-clad discipline. You can't be doubting your system or changing it every few years, much less every few months as most market timers do. Instead of just ignoring the market, you've got to follow the market and follow your system, whatever system you may decide on, despite what is in the news. And speaking of systems, should you use the 200 day moving average? The 50 day moving average? When the 50 day crosses the 200 day? Why not the 40 day average or the 190 day average? If you're going to backtest data, surely nice round numbers like 50 and 200 weren't the best. The data on buy and hold investing is quite robust, it's easy to put faith in, and the execution is remarkably simple.

5) Where are the successful trend-following mutual funds and hedge funds? If this system works so darn well, someone ought to be willing to do it for a few basis points of AUM fees. The fact that nobody is doing it successfully on any kind of large scale is an awfully big indictment of the system. Where is the Warren Buffett of trend-following? Where is the guy who actually used one market timing system for the 25 years noted in the study above? Surely there's someone, no? Even the “study” listed by my opponent above (which looks at only a single presumably cherry-picked 25 year time period) relies on the future resembling the past in order for this system to be successful.

6) Academic studies generally find technical analysis doesn't work. Wikipedia notes only 56 of 95 studies concluded that “it works” but also notes that most of these positive studies had serious methodological flaws. Those who have studied evidence-based medicine know just how important methodology can be when it comes to results.

7) Paul Merriman, a trend-following advocate, is such a believer in the method that he keeps half his portfolio in a buy and hold system. He gives the following advice to would be trend followers:

Don’t try to do it yourself unless you are certain you can carry out an ironclad discipline through thick and thin. I promise you this: Timing’s short-term results are certain to disappoint you from time to time. Hire a professional to make the trades for you using strictly mechanical trend-following systems. You’ll find plenty of timers online, but some of them charge too much. I don’t think you should pay more than 1.5% for timing

Well, if it costs me 1.5% to hire someone to market time for me, and he adds on another 1% in costs and taxes from the timing, it looks like I've already more than eaten up any possible benefit (my opponent's “study” claims 1.76% per year) there may be in trend-following. Finally, Paul concludes this:

Just skip the whole timing thing. Nearly half a century of working with investors has taught me this: Many people who try buy and hold succeed, while most of those who try timing (particularly those who do it themselves) fail.

If that's the most articulate voice for trend-following out there, it's pretty hard to believe in it.

8) Last, my opponent advocates both paying attention to valuations and mechanically following a system. You can't do them both. At high valuations are you going to sell your stocks, or keep following the trend? Confusion on matters such as these lead to serious doubts and behavioral errors and before long, you're underperforming a simple buy and hold strategy.

While the reader can make his own decision about whether to bounce from one country to another chasing low PEs or following trends with his stocks, I'll stick with a system that requires little time, effort or knowledge and minimizes behavioral errors, taxes, and investment expenses. That approach has certainly worked for me so far, along with tens of thousands of Bogleheads.

What do you think? How do valuations affect your investing? Do you use any kind of trend-following system or pooh-pooh it as market-timing gibberish? Comment below!