I am starting a new series on tactical asset allocation techniques based on market timing. In this first part, we will look at the index PE (price to earnings ratio) as a signal. In this series, results from a backtest with Sensex and/or S&P 500 data will be presented and is one of the most comprehensive that I have undertaken so far.
I had published many articles on the index PE and did not have a favourable opinion on the idea of using it for deciding asset allocation. However, I had never changed equity in the portfolio from 0% to 100%. So let us get started with some basics.
What is meant by tactical asset allocation (TAA)?
Asset allocation is the ratio of much equity, fixed income, gold, cash etc. is present in a portfolio. We will only consider equity and fixed income in this study. Tactical asset allocation (TAA) refers to changing these allocations based on certain factors or indicators.
What is market timing?
It is a technique to reduce portfolio risk and/or enhance portfolio returns by changing asset allocation based on our reading of where the market will head in the near future. This can be the stock market, bond market, gold market etc.
Is tactical asset allocation necessary?
Yes, as the risk associated with a portfolio must be systematically reduced or contained to ensure we have enough money for our future needs.
Is market timing necessary?
No. Tactical asset allocation is necessary and one need to resort to market timing to do this. TAA is possible based on a target corpus associated with a financial goal. See: How to reduce risk in an investment portfolio and Do we need to time the market? The third part of this series is due.
Can we time the market?
Yes. However, realistic and reproducible market timing methods have often primarily reduced risk with or without return enhancement. See results here: Want to time the market with Nifty PE? Learn from Franklin Dynamic PE Fund and here: Is it possible to time the market?
To summarise, Can we time the market? Yes, we can. Do we need to time the market, No, there is no need to. If you do not understand this difference, please do not proceed further.
What is a PE?
PE or Price to Earnings ratio tells how much more (or less) the price of securities is, compared to its earnings (or what it is actually worth – an opinion).
PE = Current price per share/Earnings per share (past year/years)
A stock with a high PE is perceived to be more expensive than what it is worth and a stock with a low PE, less expensive. There is a belief (just like there is a god) that a high PE security will soon “correct”, and this need not occur at all!
What is an index PE?
It is the weighted-average PE ratio of the stocks that form the index at any point in time. If the index is based on market capitalization then the PE will also be weighted similarly. That is, higher market cap stocks will have a higher weight.
What is market timing with the index PE?
Call some PE value as “low-PE” and some other value as “high-PE”. As we will see below, these values can be pretty much arbitrary! If the current PE of the index is less than low-PE then “go all in” on equity. If the current PE is higher than high-PE, sell all equity (detailed example below). Also, see: What is a high index PE?
Warning and Disclaimer
The following is to be treated as investment research based on past data unrepresentative of practical implementation and not investment advice. They do not factor in behavioural/emotional aspects associated with investing. If you do not know how to understand a backtest result, evaluate its disadvantages, then please, please DO NOT play with your money using market timing. Please watch this video before proceeding further.
Rules of Market Timing with Index PE Ratio
We will compare two portfolios over a ten year investment period.
1: systematic investing into a portfolio of 50% equity and 50% fixed income. An amount of Rs. 1000 will be invested into the Sensex and an imaginary fixed income fund that offers a steady 6% return (this is considered to be a post-tax return). The portfolio will be rebalanced once a year. To account for exit loads and tax associated with this, the final portfolio amount will be reduced by 4%.
2: Tactical investing with the following rules. Set a low-PE and a high-PE value. I have tested with:
low-PE = 15, high-PE = 22 (15-22)
low-PE = 15, high-PE = 25 (15-25)
low-PE = 17, high-PE = 25 (17-25)
low-PE = 12, high-PE = 25 (12-25)
low-PE = 15, high-PE = 19 (15-19)
The choice of low and high is arbitrary because Sensex PE in the past has swung wildly and what is low or high is constantly changing with each passing day.
Check Index once a month.
If current PE < low-PE: Invest Rs. 2000 that month in equity(Sensex). Also, sell fixed income and invest into equity.
The fixed income sale and equity investment are considered to be done on the same day (which is impossible unless they are held as ETFs).
If current PE > high-PE: Invest Rs. 2000 that month in fixed income. Also, sell equity and invest into fixed income.
If current PE > low-PE but < high-PE, then invest Rs. 1000 in equity and Rs. 1000 in fixed income.
The final tactical portfolio is reduced by 20% (this is 5 times the amount assumed for the systematic portfolio as the average no of trades in 10Y is about 5). This 20% accounts for exit loads of equity and fixed income and tax associated with equity. Remember equity was taxed like a debt fund before 2004 and will be again taxed from the current FY. The tax associated with fixed income is already accounted for in its returns (constant 6%).
At first sight, 20% may look a bit much, but you may change your mind when you see results below. Anyway, it is better to err on the side of caution. I hope these assumptions are reasonable. A marked linked fixed income security would have been better, but let us work with these for a start. Pre-tax returns of 8%+ were easily attainable up until 2014 or so. Therefore I think 6% post-tax is reasonable for the backtest.
Market Timing with Index PE Ratio: Results
Part (a) low-PE = 15 and high-PE = 22
The internal rate of return (XIRR) which is representative (not equal) to the annualised return is shown for the two strategies.
It is clear that the timing strategy has a better return more often. Notice how sharply the timing (tactical) return fell in the recent past. This is true of all low and high PE values chosen. So you have been warned. There are 220 data points here of each colour. This corresponds to investing at the start of each month. However, investments can occur at any time of the month and in order to check we need to repeat this over all days of the month results in 6000+ unique data points. A full such run for 15-19 strategy is shown at the end of the post.
The final corpus values also follow a similar trend.
Next, we ask, what is the maximum loss of each portfolio from a peak? This is known as the maximum drawdown. This is measured as a negative no. A maximum drawdown of -15% means the portfolio fell by that much and this is biggest such fall. Also, see drawdown illustration below.
Notice that PE timing method has lead to higher max drawdowns. So do not assume that the current rules will reduce portfolio risk! I would classify this as a high-risk + potential high-return strategy. Nothing wrong with that though.
The standard deviation represents how much the monthly returns of the portfolio have fluctuated.
Notice that the tactical strategy has a higher standard deviation again pointing to the fact that it has a higher risk. The reason is simple. The portfolio often has 100% equity exposure and so the risk is higher. Instead of swinging from 0% to 100% equity, a lower swing can be tested (note to self).
Next, we consider the total no of months the portfolios were underwater (that is the no of months the portfolio fell from a peak to a low). That is the no of months the drawdowns were negative. Here is an example.
Notice the drawdown points on the left. The first time the portfolio dips from a peak the drowdown is -1% (non-zero). So that is the first month underwater. The highest such fall is the max drawdown above.
The total no of dips from a peak for the tactical portfolio is lower, however, the maximum such dip is higher!! Next, we look at no of continuous months the portfolio was lower than its most recent peak.
That is the no of red dots within the rectangle. This tells you how long it took for the portfolio to recover.
The tactical strategy did recover faster than the systematic strategy.
Then we look at how many times equity was sold over each 10-year period considered.
This is extremely reasonable! Only about 5 trades is fantastic. It keeps taxes and exit loads lower. For the systematic strategy, the rebalancing will involve a sell-off if the equity allocation was higher than 50%. I did not count how many times this occurred (note self: count this).
Finally, we consider the no of months when the portfolio had no equity allocation and no investment in equity.
Notice that with this strategy you may have to say goodbye to equity for about 2Y (more sometimes) continuously (red) and the total months of no equity could be higher (green). This is where the behavioural or emotional aspects will kick in.
People who think that market timing is more exciting should stare at this long and hard. It is boring and requires a lot more discipline than the systematic approach.
We will compare different low and high PE methods tomorrow.
Full data for low-PE = 15 and high-PE = 19
Notice that the no of tactical XIRR data points having lower or comparable return to systematic XIRR have increased when we look at the full set. Please keep this in mind!! When you try this strategy, it may not be successful. Never forget Common Sense 101: The difference between probability and possibility
While the results clearly point to higher returns for the timing method, this particular approach also increases portfolio volatility. The no of falls are less, but when do occur, they could be large. So dont get caught up into “buying low and selling high is commonsense”. Commonsense not backed by hard proof is a hallucination
The no of equity sell-offs is reasonable but the time in which the portfolio has no equity investment is pretty high. In this day and age of information overload, it may be difficult for the investor to avoid all noise and stick to their course. Market timing needs a whole lot more discipline than setting up a SIP. Market timing is therefore pretty boring!
Will I adopt this strategy? No, because I don’t need to. I can manage risk with my goal targets. Also, I cannot stay away from equity investing for this long.
Should you adopt this strategy? Not my problem. You will have to figure it out.
Does this strategy work? The backtest says yes but keep in mind the assumptions made, real-life limitations, the fact that in the recent past results are not that good and that it is only a back-test.
Note: I will not answer any personalized question regarding this strategy. Also, the excel sheet used will not be shared. I consider it a proprietary research tool and will not share it until I milk it dry.
Connect with us on social media
- Twitter @freefincal
- Subscribe to our Youtube Videos
- Posts feed via: Feedburner
- We are also on Google PlusandPinterest
Do check out my books
Get it now. The Kindle edition is only Rs. 199.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You WantMy second book is now only Rs 199 (Kindle Rs. 99) Get it or gift it to a youngearner
The ultimate guide to travel by Pranav SuryaThis is a deep dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, how travelling slowly is better financially and psychologically with links to the web pages and hand-holding at every step. Get the pdf for ₹199 (instant download)
Free Apps for your Android PhoneAll calculators from our book, “You can be Rich Too” are now available on Google Play!
Install Financial Freedom App! (Google Play Store)
Install Freefincal Retirement Planner App! (Google Play Store)
Find out if you have enough to say "FU" to your employer (Google Play Store)