We know from both Easterling (fundamentals) and Prechter (technicals) that stock prices rise and fall over secular cycles. We know based on CAPE and Elliott wave analysis that a secular bear started in 2000. The big question is where (and when) will the bear end.
However, is it imperative that investors determine where stock prices will land and at what valuation? OR is it not more important that investors simply weigh the consequences of having a majority allocated to stocks such as 60/40 and simply shift to a more conservative mix of 40/60 or 30/70.
Secular Bulls & Bears
The following diagrams (not to scale) summarize the trajectory of secular stock prices covered in Easterling’s fundamentals research utilizing the cyclically adjusted price to earnings (CAPE) of the S&P 500 first introduced by Shiller.
The following diagram (not to scale nor requirements) summarizes the trajectory of secular stock prices representative of a five-wave bull fractal covered in Prechter’s technical research utilizing the Dow Jones Industrial Average Index.
Asset Allocation
Markowitz’s Modern Portfolio Theory (MPT) was introduced to the financial services industry through Ibbotson Associates in the form of strategic asset allocation (SAA). The intrigue among advisors and trust departments at the time was the “free lunch” in the form of lower risk and higher or equal returns via negative (and low) correlated asset classes that could be illustrated via software programs like Frontier Analytics AllocationMaster. Unfortunately, the 2000-2002 and the 2008-2009 bear trends in stocks blew a hole in MPT since we learned that correlations are not only unstable but increase exponentially during a stock market meltdown, therefore, turning Sharpe’s CAPM theory (greater risk = greater return) upside down.
From “A Dynamic Asset Allocation Approach to Investing,” we learned that CAPE can be utilized to optimally allocate (across stocks, bonds, and cash) during secular bears in which stock valuation has peaked and is falling and prices are moving sideways via bull and bear trends.
Relative & Absolute Returns
If investors know what type of secular cycle they are in based on Easterling’s and Prechter’s work, then would it not be rational to assume, therefore, that investors should focus on strategic asset allocation and measure risk-adjusted relative returns via MPT statistics (standard deviation and Sharpe) during secular bulls and dynamic asset allocation and measure risk-adjusted absolute returns utilizing Post-MPT statistics (Cumulative Gains/Losses, Sortino, Omega) during secular bears?
Where are we today (and where will we land)?
We know based on CAPE and Elliott wave analysis that a secular bear started in 2000. The big question is where (and when) will the bear end. Here is a diagram of the current projected secular wave utilizing CAPE and Elliott wave analysis.
Safe Relative Withdrawal Rates
However, is it imperative that investors determine where stock prices will land and at what valuation? OR is it not more important that investors simply weigh the consequences of having a majority allocated to stocks such as 60/40 and simply shift to a more conservative mix of 40/60 or 30/70.
The granddaddy industry-standard 4% systematic withdrawal rate may have originated with CREF’s (College Retirement Equities Fund) variable annuity assumed investment return (AIR). It may have been supported over the years by the individual investor financial planning community since it is widely recognized that a 10% assumed return on large-cap US stocks was (and still is) being used not just in optimization for SAA but also for Monte Carlo simulation in determining appropriate systematic withdrawal rates in retirement. We also know from Easterling’s research that Monte Carlo simulation is simply the other side of the MPT coin. Based on the dynamic asset allocation approach to investing in stocks, bonds, and cash (Grennon), why would investors not consider a more pragmatic approach and prudent safe relative withdrawal rate (SRWR) based on CAPE and yields? For example, if the CAPE is in the 95-100% historical valuation which translates into a 1% assumed return on stocks and yields on bonds is 2% (assumed return on bonds) then would it not be more safe and prudent then to withdraw 40% of the assumed investment return based on your mix. So a 60/40 mix has a 1.4% (60% of 1% + 40% of 2%) assumed investment return then the traditional 4% systematic withdrawal rate/10% return on investments rule of thumb translates into 0.56% SRWR.
The obvious alternative would be to shift to a heavier bond allocation to increase your safe relative withdrawal rate.
Consider the following example(s)
References
Easterling, Ed (2010). Probable Outcomes: Secular Stock Market Insights. Cypress House.
Prechter, Robert R. Jr. Beautiful Pictures from the Gallery of Phinance. New Classics Library.
Grennon, Terry. (2015). “A Dynamic Asset Allocation Approach to Investing.” SSRN.
For more information: Is your asset allocation strategy prepared for the bear market?
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