Stock Market Timing Using Valuations

A reader asks:

My asset allocation has been pretty conservative since the market started in 2020. My basic thesis is that the market is overvalued and the only way I can stay in stocks is to have a 60/40 stock/bond allocation. One thing I like about the 60/40 split is that it gives me the option to switch to a more aggressive allocation if stock valuations fall. I have nagging doubts that my allocation isn’t aggressive enough given my age (41), so I thought about how I could convince myself to be more aggressive. For the past week, I’ve been trying to put down a simple strategy. Ideally, my strategy would have a line like “If market valuation X falls below Y, switch to a more aggressive asset allocation.” This made me realize that I don’t know a good way to do this. I’ve used the S&P 500’s cyclically adjusted value ratio to convince me that stocks are overvalued, but I don’t know if it can be used as an indicator for my plan. Price to earnings peak appears to be another option. I’m curious if you can provide a better method or indicator, or if you just hate the idea of ​​this “market timing light” in general.

I like the idea of ​​investing based on a predetermined plan.

Making good decisions ahead of time is one of the best ways to outsmart your lower self, especially when emotions are high during a bear market.

It also makes sense to use your fixed income allocation as dry powder. If you want to buy when there’s blood in the streets, you need a source of liquidity. This is one of the beauties of a diversified portfolio.

Overbalancing when stocks are down sounds like another wise move. This is the kind of thing where you can place bands or ranges around your allocations that help you determine how aggressive you can get when stocks are on sale.

Where you lost me is using ratings to time the stock market.

I have never found a legitimate way to use valuations to determine entry or exit points in the stock market. Maybe when things go to extremes, but even then assessments can be unreliable.

In early 2017, I wrote an article for Bloomberg about stock valuations:

This was lede:

Something happened in the stock market this week that has only happened twice since 1871: Robert Shiller’s preferred method of valuing the S&P 500, the cyclically adjusted price-earnings ratio, hit 30. So it’s time to do you worry

The only other times in history when the CAPE rate reached 30 were in 1929 and 2000, just before massive market crashes. So it made sense that some investors were worried about the stock market being overvalued.

The S&P 500 is up nearly 170% since then, good enough for annual gains of about 14% a year.

Sometimes valuations matter, but other times, the market doesn’t care about price-to-earnings.

The same is true during bear markets. Sometimes stocks get downright cheap, but not all the time.

I looked at the CAPE ratio, trailing 12-month P/E ratio, and dividend yield on the S&P 500 at the bottom of each WWII bear market:

Averages might look like solid entry points, but averages can be deceiving when it comes to the stock market.

In the past, valuations reached much juicier levels at the bottom of a bear market. But it is also true that the original valuations in the 1940s, 1950s, 1960s and 1970s were much lower. Dividend yields were also much higher than (mainly because there weren’t as many share buybacks).

Three of the four bear markets this century have not seen the CAPE ratio near previous bear market valuation levels. If your plan was to get more aggressive when the market got cheap enough, you would wait longer.

The problem with using valuations as a timing indicator is that even if it works on average, missing a single bull market can be devastating. You may wait a long time to get back into the stock market and lose big gains in the meantime.

I’m not a big fan of market timing in general, but if you really want to be more aggressive during a bear market, I prefer to use predetermined loss thresholds.

For example, every time stocks fall 10%, 20%, 30%, etc., move a certain amount or allocation from bonds to stocks. It’s a much simpler plan that removes the vagaries of time ratings so you don’t miss a buying opportunity. Buying stocks when they are down is a pretty good strategy.

Of course, no one knows how far stocks will fall in a bear market, but I would trust price declines over valuations.

There have been 13 bear markets since the end of World War II, or one every six years, on average. A double-digit correction occurs two-thirds of each year. You can’t set your watch to these averages, but the risk is more reliable than stock market valuations.

The good news is that you didn’t completely exit the stock because you felt the market was overvalued. Extreme positions are the killer when it comes to market timing.

My usual advice to investors is that you should choose an asset allocation that you would feel comfortable holding during bull markets, bear markets, and everything in between. Getting more conservative or aggressive seems like a smart strategy until you get it wrong at the wrong time.

Market timing is tough. Ratings don’t make it any easier.

We covered this question in the latest episode of Ask the Compound:



My personal tax advisor, Bill Sweet, joined me on the show again this week to address questions about optimizing taxable retirement accounts vs. tax-deferred, the 401k trap, rolling over an inherited IRA, and the tax considerations of moving aboard.

Further reading:
The difference between market timing and risk management