U.S. Stock Market

Remains in a Bubble

DYI:  Below is John Kingham’s valuation formula for purchasing/selling stocks and bonds.  I have changed the formula to reflect Ben Graham’s Defensive investor 50% stocks and 50% bond.  If valuations are at its mean stocks and bonds will be at 50%/50% level only deviating from that as stock valuations rise or fall. 

Excellent tool for those investors desiring a more cautious, smoother ride in the markets, as opposed a high fixed stock to bond allocation.   Retirees handling a large lump sum for their nonworking years thus requiring downside protection. Large commitments to stocks only when the market is undervalued in its extreme.  This is the classic income plus capital appreciation type of investing.  

%
Stock & Bonds

Allocation Formula

04-01-19
Updated Monthly

% Allocation = 100 – [100 x (Current PE10 – Avg. PE10 / 4)  /  (Avg.PE10 x 2 – Avg. PE10 / 2)]

Current PE10.....30.50

Avg. PE10......... 16.61

% Stock Allocation   0% (rounded)
% Bond Allocation  100% (rounded) 

Logic behind this approach:

--As the stock market becomes more expensive, a conservative investor's stock allocation should go down. The rationale recognizes the reduced expected future returns for stocks, and the increasing risk. 

--The formula acknowledges the increased likelihood of the market falling from current levels based on historical valuation levels and regression to the mean, rather than from volatility. Many agree this is the key to value investing.  

Please note there is controversy regarding the divisor (Avg. PE10).  The average since 1881 as reported by Multpl.com is 16.70.  However, Larry Swedroe and others believe that using a revised Shiller P/E mean of 19.6 , the number since 1960 ( a 53-year period), reflects more modern accounting procedures.

DYI adheres to the long view where over time the legacy (prior 1959) values will be absorbed into the average.  Also it can be said with just as much vigor the last 25 years corporate America has been noted for accounting irregularities.  So....If you use the higher or lower number, or average them, you'll be within the guide posts of value.

Please note:  I changed the formula when the Shiller PE10 is trading at it's mean stocks and bonds will be at 50% - 50% representing Ben Graham's Defensive investor starting point; only deviating from that norm as valuations rise or fall.        

  

DYI

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The Formula.

A value based allocation strategy

February 19, 2010 by John Kingham