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A tactical value approach for 401k accounts

A low-fuss absolute value approach for accounts with limited options

There is an old rule of thumb that your percentage allocation to bonds should be 100 minus your age. This is because bonds are about half as volatile as stocks, and the older you are, the more you can be hurt by volatility. Ideally, a portfolio should be meaningfully diversified with foreign stocks and bonds, commodities, and REITs, but many 401(k)s don’t have many options beyond US stocks and bonds. After ten years of rising equity prices, few older investors are holding age-appropriate allocations in such accounts. This is especially concerning in light of the low returns and high risk implied by current equity valuations. But for those who are afraid to miss out, there are ways to reduce risk without permanently retiring from stock investing.

One elegant method for setting a risk-appropriate stock and bond allocation is to scale into a larger equity allocation when equity markets are objectively cheaper as measured by the CAPE ratio, and to lighten up and hold more bonds as stocks get more expensive. The premise is that returns to stocks are higher when cheap and lower when expensive. Conversely, downside risk is higher when stocks are expensive and lower when stocks are cheap. There is no need to try to read the economic tea leaves or follow earnings reports. All we need is a quantitative measure of valuation that has proved to have a high correlation with future returns, and CAPE is a sufficient and widely available statistic.

The rules for the Universal Value Model are as follows: 

80% invested in the stock market when cheap (CAPE<12);

60% invested when fairly-valued (12< CAPE<22);

20% invested when expensive (CAPE>22).

The remaining balance is invested in 10-year US Treasuries.

I track this model for 20 global stock markets in the Value and Momentum Monitor, and we employ it for clients with outside 401(k) accounts that can’t be actively managed on a monthly basis. An annual or semi-annual check-up is all that is required, and action need only be taken when valuation thresholds have been crossed, so you can go many years without altering these portfolios beyond annual rebalancing.

Here are the results of such a process applied to the S&P 500, and again on the EAFE index of international developed stocks. In each case, we use 10-year Treasuries as our bond allocation. Below we compare the results to conventional 60/40 allocations as well as the respective stock indices alone. 

This tactical approach has produced steadier returns with less downside than either stock index or 60/40 allocation. Stock valuations were low in the 80s, so the value portfolios were heavily weighted towards stocks and performed in line with their indices. They then reduced exposure near the top of the dot-com bubble and completely side-stepped the 2000-2003 bear market. In 2008, they avoided the brunt of the damage, only dipping heavily into stocks after they had fallen significantly, although before the very bottom.

Here’s a test on the S&P 500 going back to the 1920s, with drawdowns below. The model would have spared investors some pain in the great crash of 1929-1932, and then gone heavily into stocks once valuations were low, such that the portfolio recovered faster than 60/40 or stocks alone (the zero line in the bottom chart means new all-time highs), staying ahead of stocks until the bull market of the 1950s. In the 1973-1974 bear market the value model performed in line with 60/40, as valuations were in the mid-range going into that crash, and it then sailed along smoothly right up to 2008, again recovering quickly.

At present, the US value model is again heavily weighted towards bonds, and it would not be surprising to see the alligator mouth in the charts close a bit in the coming years. It is from times like today with very high equity valuations (US CAPE is over 30) when scaling out of stocks proves most rewarding. There is no need to time the exact top. You simply pare back exposure while downside risk is elevated and returns are unlikely to be sustained, and wait patiently for prices that offer a greater margin of safety and promise better compensation.

As always, we don’t need a forecast, just a model for managing risk. This low-maintenance value model is almost as easy as “sell in May and go away,” so don’t hesitate to get in touch this summer if you have a portfolio in need of a checkup.

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