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I've created my own asset allocation strategy called the Market Level Allocation Strategy (MLAS). As the name implies, MLAS is influenced by how high or low the stock market is relative to historical performance. If, for example, the stock market is high, then more of your asset allocation will go into bonds and vice versa.

MLAS is relatively easy to apply, but understanding the rationale behind it, which is the focus of this article, is a little more complicated. This article assumes that you already understand Shiller PE,BV# which is also known as PE10.

Common Sense Rationale

You can use Shiller's PE chart to place bets on the direction of the market. In other words, if the current PE10 is 30, is the stock market likely to go up or go down in the next several years? My bet is that it will go down. I can't say exactly when it will go down, but if I bet that the market will go down, then most of the time I'll be right. The number of times that I'm right will more than make up for the fewer times that I'm wrong.

I'm not much of a poker player, but I think the situation is similar to poker. I don't have perfect information, but I know the probabilities of getting various hands. If I use those probabilities, I can't win every hand, but I will likely win more often than I lose.

You may be thinking that any basic asset allocation strategy is already inherently using these probabilities through rebalancing. For instance, if the market goes up and you rebalance, then you'll sell some stocks and buy some bonds. As a result, you're already betting that the stock market will go down and bonds will go up. That's true, but MLAS amplifies the bet.

Research Support

Wade Pfau's research supports using PE10 as a mechanism for adjusting your asset allocation. He summarized his research as follows:

On a risk-adjusted basis, market-timing strategies [using PE10] provide comparable returns as a 100 percent stocks buy-and-hold strategy but with substantially less risk. Meanwhile, market timing provides comparable risks and the same average asset allocation as a 50/50 fixed allocation strategy, but with much higher returns.

Pfau's asset allocation strategy involved modifying the allocation percentages based on the current level of PE10. If the PE10 was above its rolling median, he would increase his stock allocation percentage. If it was below the median, he would decrease his stock allocation percentage. He used a rolling median so that he would only use the information available at the time of the allocation decision. Here is a selective summary of his results:

Summary Statistics for Pfau's Market Timing Research
StatisticFixed - 100% StocksFixed - 50% Stocks / 50% BondsMarket Timing - 20% or 80% Stocks
Arithmetic Return10.13%7.46%8.63%
Geometric Return8.60%7.08%8.08%
Maximum Draw-down61%29%18%
Sortino Ratio1.0371.4901.829
Average Stock Allocation100%50%52%
Average in 2010 of $1 invested in 1871$95,404$13,426$49,068

The table shows three allocation strategies that are rebalanced annually when necessary:

  1. Fixed - 100% Stocks: This is a fixed allocation strategy with 100% allocated to stocks. Of course, no rebalancing is required with this allocation strategy.
  2. Fixed - 50% Stocks / 50% Bonds: This is a fixed allocation strategy with 50% in stocks and 50% in bonds. This is a typical asset allocation strategy.
  3. Market Timing - 20% or 80% Stocks: This is a market timing allocation strategy that oscillates between 20% (if market is above the PE10 rolling median) and 80% (if the market is below the PE10 rolling median). The remaining assets would go into bonds.

The table also shows that the greatest returns are for the 100% fixed asset allocation strategy which is not a surprise. What is a surprise is that the market timing strategy beats out the 50/50 fixed allocation strategy by at least 1%. The ending portfolio value of $1 invested is much higher for the market timing allocation strategy ($49,068) then it is for the 50/50 fixed allocation strategy ($13,426).

The 100% fixed allocation strategy provides the highest returns, but at the price of higher volatility.The Sortino Ratio which is a measure of downside risk is the worst for the 100% fixed allocation strategy and the maximum draw-down or loss is a painful 61%.

The market timing strategy is less volatile than the other strategies with a maximum draw-down of only 18%. The market timing strategy also has the best Sortino Ratio. Ironically, the average stock allocation is very similar between the market timing allocation strategy and the 50/50 fixed allocation strategy.

For the market timing strategy, Pfau's research also found that the average time for shifting between 20% and 80% allocations was about 5 years. The market timing strategy didn't involve lots of extra trading.

Major Assumption

I and Pfau are both assuming that the way the market behaves in the future will be similar to the past. I'm comfortable with this assumption because in the stock market, the more that things seem to change, the more they stay the same.

There have been periodic arguments that "this time is different" that turned out to be bogus. Remember the "New Economy" during the Tech Boom in early 2000? Investors thought that the actual structure of the market was different, but it turned out that you still need profits for an investment to make sense.

Source: Asset Allocation With A Market-Level Tilt