Is the stock market going to take off from here, or are we in for another big downturn? I want to provide a framework for thinking about today’s market valuations in their historical context.

In 2003, Ben Stein and I wrote a book titled, Yes, You Can Time the Market.  It was a meditation on the valuation of the S&P 500 throughout the 20^th century. We investigated the utility of metrics like the price-to-book ratio, price-to-earnings ratio, price-to-dividend ratio, etc. to value and hence time the market. We discovered – unsurprisingly – that if you bought stocks when valuations were low, your long-term returns going forward tended to be much better than if you bought when valuations were high. 

Bear Market – an 18-to-24 month period when the kids get no allowance, the wife gets no jewelry, and the husband gets no sex. -- Investor’s Glossary

October 9, 2008 marked the one-year anniversary of the bear market in U.S. equities. This seemed like a good occasion to review the performance of all the portfolios presented in Ben Stein’s and my book, Yes, You Can Supercharge Your Portfolio. The book was published in December 2007 and the portfolios it contains were devised in sunnier times, during the preceding summer. Our goal was to popularize Modern Portfolio Theory among retail investors, and we relied heavily on Geoff Considine’s Quantext Monte Carlo simulator [QPP]. Had we known the stock market would decline almost 50% after constructing the didactic portfolios in the book, we would have titled it Yes, You Can Put Brakes On Your Portfolio’s Descent into Hell.

In our new book Yes, You Can Supercharge Your Portfolio, Ben Stein and I describe a series of investing stages. We hypothesize that most investors do not begin with an overarching theoretical framework for their holdings, but rather own what we term a “Glom” (for agglomerative) portfolio, made up of scraps of whatever looked good at the time they made the initial purchases. The problem with this “cats and dogs” approach is that there is no overall sense of what it means: the likely risks and returns are unknown, as is its suitability to meet the investor’s short- , intermediate-, and long-term goals. There is no match between assets and liabilities, or knowledge of whether the assets are invested in an efficient manner.

We recommend that investors in this position could “supercharge” their holdings by moving toward what we call a “Glob” portfolio – a great global glob of securities held in some conventional, common-sense allocation. This is essentially the John Bogle move: using index funds to pursue a low-expense, highly diversified set of holdings. This captures the free lunch of low expenses and a market-wide degree of diversification to improve the risk/return portfolio efficiency in harnessing the returns from global capital markets. For many investors, we think this would be a giant step forward.

An excerpt from the new book Yes, You Can Supercharge Your Portfolio - reprinted with permission of authors Ben Stein & Philip DeMuth and publisher:

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Ben Stein and I wrote Yes, You Can Supercharge Your Portfolio to demonstrate the practical value of Modern Portfolio Theory to a mass audience. It had long struck us that many investors still operate under a pre-Markowitz paradigm, trying to outperform the market by picking hot stocks and five-star mutual funds. In the book, we argue that a better approach is to seek massive diversification among and within asset classes in order to attain the best risk/return tradeoff for a portfolio. We further recommend that portfolios should be checked through forward-looking Monte Carlo simulations, and provide some practical examples. In contrast, merely extrapolating from historical returns to an asset allocation can lead to poorly-performing allocations, as shown in William Bernstein’s The Intelligent Asset Allocator. Forward-looking models can provide more realistic estimates of future risk and return.

We didn’t know then that stock markets would be in the middle of a major correction by the time the book was released. The analysis and results in the book all had been generated using market data available through 2006. The portfolios we presented as examples all looked fine as we went to press (thanks to Geoff Considine’s Quantext Monte Carlo simulator, QPP), but they were to be severely tested as the book reached the stands. This paper examines the performance of three teaching portfolios we discuss in the book during the recent market decline from 10/31/2007 to 1/31/2008.