Strategic investing: Value investing without the market timing

by Pop on May 5, 2010

Post image for Strategic investing: Value investing without the market timing

Thanks to everyone who filled out my survey and entered the $10 gift card drawing. The responses were extremely helpful. I received 126 entries and e-mailed the two winners a week ago. They were lava**** and josw**** If your e-mail address resembles one of those, and you didn’t get a code in your inbox, check your spam folder and then contact me using the contact form. Anyway, thanks again to everyone who participated!

Active and passive investing aren’t mutually exclusive.

When you first start investing, it’s hard to get over the bipolar options that financial advisors and media throw at you. You’re told that you can either be an “active” investor, who employs market timing, tries to beat the indexes, and pays a bit extra for mutual funds. Or you can be a passive investor, who picks the lowest cost index funds available and allocates assets based almost exclusively on age and risk tolerance.

I don’t know about you, but I find both options pretty unsatisfying. It’s been well established that going whole-hog active is a recipe for losing a lot of money. But it’s also pretty clear from psychological studies that completely ceding control of something as important as our retirement nest eggs makes us, well, unhappy.

I wrote in a previous post that one solution to this is to give yourself a sandbox—devote 5% of your portfolio to beating the market and stick with a plain-jane age-based allocation strategy for the rest.

But today I’m going to explore something different. What if you tried just a little bit of market timing with your whole portfolio?

The safest way to value invest

Jeremy Grantham, a usually bearish fund investor, likes to say that his firm makes big bets on extremely likely outcomes. That is to say, he takes a huge uppercut on fat pitches. He loses big if the swing misses, but if he’s right, they crush the ball and make a lot of money.

Sadly, you and I are not Jeremy Grantham-level investors. We are minor leaguers at best. We might think we see a great company selling at a fire sale price, but we’re wrong often enough that taking that huge swing could lose us more than we can afford to lose.

If you can sit back and play the averages with indexing, more power to you. But if you want to do something with that fat pitch, here’s how to make slight adjustments without betting the farm.

1. Recognize when the market’s frothy or cheap.

“Easier said than done,” you might say. And you’re right, to an extent. But as tough it is to see if the market is slightly over or underpriced, it’s actually pretty easy to see if it’s way over or underpriced.

You see, way back in 2000, at the height of the internet bubble, this Yale professor named Robert Shiller, whom I’ve mentioned way too many times on this blog, wrote a book describing just how out-of-whack the stock market had really become.

The book, Irrational Exuberance, seemed unbelievably pessimistic at the time. It basically argued that stock prices were multiples higher than they should have been. It turned out that Shiller was right. Then, Shiller did a similar analysis on the real estate market and was right again. Suddenly, Shiller’s methods became something that investors pay a lot of attention to.

What exactly was Shiller’s brilliant strategy? Actually, it was kind of simple. There’s no fancy computer algorithm backing this investment strategy up. It’s summed up in an Excel spreadsheet, downloadable off Shiller’s website, that a middle-schooler could have built in his advanced computers class. But despite its simplicity, I’m fairly sure it’s one of the most downloaded spreadsheets in the history of the internet.

All Shiller did was take the current price of the S&P 500 and divide it by the average of the last ten years of the S&P 500′s earnings. It was basically a modified price-to-earnings ratio, brilliant in its simplicity, and mirrored in some of the very traditional investment approaches of Benjamin Graham, Warren Buffett, and others.

Using a 10-year average of earnings smoothed out the earnings peaks and valleys typical of a cyclical economy. That way, you wouldn’t be tricked by a seemingly low P/E when they peaked or a high P/E in severe recessions, like the one we just went through.

Looking back at market prices and earnings for a little more than 100 years, Shiller found that the market’s average P/E10 (the shorthand when you use 10-year earnings) was about 15. What’s more, if you invested when the market was at a high P/E10, your returns for the next 10 years were almost certain to be much less than if you invested when the P/E10 was below 15.

There were exceptions. The late 90s bull market, for example, lasted for an extremely long time. But even in that case, it basically just took a little bit longer for Shiller’s prediction to play out.

Now, of course, the most pertinent question: Where is the P/E10 now? Lucky for us, Shiller updates his Excel sheet every month. Right now, it’s at about 21.67. That’s high. Not nearly as high as it was in late 1999 (44), but way up from the low last March (13).

Despite our tentative conclusion that the market is relatively expensive, remember that we’re not taking a huge uppercut here. What do we do?

2. Slightly tilt your portfolio.

I’m going to assume that you’re already familiar with the usual, age-based stock/bond allocations talked-up by the mutual fund industry (and me). If you’re not, the oversimplified version is that you should put in stocks 110 minus your age. In other words, a 30-year old would put 80% in stocks and the remaining 20% in bonds. A five-year old would put all of his nickels in stocks and then steal an extra 5% from a weaker kid to supplement it (just kidding).

With this information, Grantham might put a huge portion of his money in safe assets and very little in U.S. large-cap stocks. But we’re not Gratham. We don’t want to lose a whole lot because our rudimentary measurement went wrong.

So instead, just slightly tilt your portfolio toward bonds. The 30-year old might put 75% in stocks and 25% in bonds. If the P/E10 were 40 instead of 22, he might put 70% in stocks (or if he were really crazy, 65%). But the overall message here is that he’s not risking it all, while still making room to adjust for an expensive market.

If he’s wrong? His portfolio will lag where it would have been by a couple percentage points at most. If he’s right? He’ll excel by a couple percentage points.

Kind of a cop out, you might argue. But hey, you didn’t expect me to reverse my position, did you?


{ 3 comments… read them below or add one }

Rob Bennett May 5, 2010 at 10:51 am

Kind of a cop out, you might argue. But hey, you didn’t expect me to reverse my position, did you?

It’s a helpful, constructive, positive, life-affirming “cop-out”, in my assesssment. It gets people thinking about the right things.

I’d like everyone to understand that I did not start out thinking that Buy-and-Hold was dangerous. Like most others, I presumed that it worked just fine. A strange set of circumstances forced me to spend a lot of time studying the data. The more I studied it, the more amazed I was at how big a role valuations play in making long-term investing success possible or impossible.

There’s room for lots of different viewpoints. I am today at one end of the spectrum of reasonable opinion. You are at a different place on the spectrum of reasonable opinion, Pop. Each person comes at these questions from a different set of life experiences that places him or her at a different spot along the spectrum.

The key is that we all just keep talking it over. That’s how we all learn. That’s how we all (including me!) advance in our understanding. Thanks for another thought-stimulating post.


dan May 5, 2010 at 2:05 pm

any idea if shiller is using earnings numbers that include/exclude extraordinary items to calculate the ratio?

Mike May 5, 2010 at 8:55 pm

When I read that you were talking about a strategy between passive and active investing, something else came to my mind.

I know a lot of hedge fund managers that try to track a specific index, for example the Dow 30, but will just underweight the companies that they think suck.

Leave a Comment

Previous post:

Next post: