TAA Vs. Buy And Hold In Overvalued Markets (CAPE > 30 Edition)

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Includes: BXUB, BXUC, DMRL, EPS, IVV, PPLC, RSP, RYARX, SDS, SFLA, SH, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU-OLD, SPXV, SPY, SSO, UPRO, VFINX, VOO
by: Paul Novell

I was thinking this morning that with the increasing talk of market valuation, bubbles, etc., it would be a good time to revisit my post on TAA vs. buy and hold in overvalued markets from 5 months ago. Read that post for a background on the analysis I did below. Since we're at a new level in CAPE ratio, above 30 now, let's re-run the analysis I did in my earlier post but do it now for years where the market has been above a CAPE of 30.

Here are results of forward returns from markets where the CAPE was above 30 compared to one TAA strategy (Antonacci's GEM). For more information on TAA see my Portfolios page. I would expect results would be similar for most TAA strategies.

If you compare the table above with the one in my previous post, you'll see that the spread between the S&P 500 average forward returns and the GEM average forward returns increases at higher CAPE levels. This is true for all holding periods. The sample size is not huge - 6 out of the last 88 years have had CAPE levels of 30. Note that ALL returns are lower, even for the TAA strategy, from higher valuations but the drop for buy and hold is worse than for TAA.

So, I wouldn't change my summary from the earlier post much, except maybe that the odds are higher now.

In summary, a TAA strategy is a powerful alternative to buy and hold, especially in periods of high market valuation. While returns for TAA in periods of high valuation are also lower than their long-term averages, they are significantly better than buy and hold and maybe more importantly with much lower drawdowns. Just like with any strategy that is different, it also comes with its own set of challenges, but the odds are that it will have better outcomes going forward.

Of course, that doesn't mean the market can't go to higher valuations. If you want to see a case of valuation really run amok, just look at the Japanese bull market that ended in the late 1980s. Michael Batnick had a great post on the Japan bubble a few months ago that is well worth your time and bookmarking. Here's the craziness chart. It's one thing to say the market can stay irrational a lot longer than you can stay solvent, but it's quite another to see a real historical example staring at you.

Valuations in Japan hit a peak CAPE level of 94! After the Japanese market hit a CAPE of 40, it continued on and rose another 3x! It went up 67% after hitting a CAPE of 80! Crazy. This is obviously an extreme example, but well worth remembering.

In short, considering where we are, where we've come from, what several historical examples illustrate, TAA is a reasonable portfolio approach in today's overvalued markets.