Portfolio evaluation and correcting for the wealth effect

[IlliniDave]

what are "relatively stable value assets" these days tho

I'm using cash equivalents (money market funds), intermediate term bonds, and I'm considering a "stable value fund" in my 401(k), which I think is basically a short-term bond fund paired with an insurance product. My use of "relatively" is significant as their are no guarantees.

[classical_Liberal]

but for me the discounting is just a look at a highly unlikely scenario (the need to raise a ton of cash quickly).

I think the main reason I maintain a set of sorta conservative metrics is really to create a shock absorber for myself--if I wake up one morning with a 50% haircut I've at least played through the scenario mentally.

I don’t discount my equities 50% because I believe that is their correct value.
It’s what I consider a realistic “worst case scenario”.
Visualizing this eventuality I believe would help me deal with it should it materialize.

This makes sense to me from a psychological standpoint, if the overall investment strategy is along the line of J.L Collins The Simple Path to Wealth. Anyone following this strategy will not sell no matter how one discounts their portfolio. So it's just a mental preparedness exercise.

There is no point in selling. Not all assets are overvalued but at least some are. If you agree with this then you tilt things in your favor with value stocks or funds and then build in a fudge factor for the inevitable overvalued things you didn't identify.

This is at the heart of a noncorrelation strategy, it's exactly the way I invest. Which was one of my points. Capital must go somewhere. So if one wants to downward adjust US equities to mean CAPE, it's probably not wise to downward adjust to mean 10yr treasury yield and mean gold:DOW as well. It's very likely that if a reversion to mean CAPE takes place, other assets will infate (or at least remain inflated) during the equity losses. The relationships between these investments are not random. So, to assume a situation in which every asset deflated simultaneously AND none of the classes rebounded to provide at least historical mean returns going forward, is assuming an extremely unlikely event. Really, a SHTF doomer situation. I'm not saying this is impossible, i'm just saying planning for this scenario has so many type II error risks that they will almost certainly end in some form of failure.

My question was leading, obviously, if one is going to make future assumptions based on doomer situations, it seems to me that person must believe doomer will be reality. In that case it makes very little sense to stay the course with investments that are going to lose real value. I know for a fact, some here, like @BSOG and @MI, put their money where their mouth is, so to speak. My question is for anyone who believes it to be enough of a future possibility they feel they need to act on it in daily actions and discount their entire portfolio this way. Yet take no action to their portfolio to rectify the situation as best possible. IOW, say the sky is falling, then run outside to bask in the sunshine.

[classical_Liberal]

Just to make one more point relevant to the OP. If we are, in fact, in a situation where we should be discounting our portfolios by 25% or more, isn't now the time we should spend more? If we can sell inflated assets to purchase tangible goods or services that we would likely utilize at some point anyway, now is the time to do it, no? I'm not suggesting go out and buy something for the sake of buying it, but if one is going to take a year-long world travel trip at some point in life, sell some of your VTI now to do it! Need that tool or land? Need a sabbatical?

[5ts]

@classical_Liberal
You make a lot of good points in your last two posts. I don't even entertain a true doomer/SHTF scenario because I would not survive said situation for a few reasons. Plus, it's utterly depressing and not really living. And addressing your point about spending more now, I am now more inclined towards a comfortable present than a comfortable but uncertain future. Things change, uncertainties arise, life gets weird sometimes. But I am still relatively conservative with investments and don't expect that to change, but who knows? Flexibility is critical.

[forest_turtle]

I been a long time follower of the CAPE10 and believe it is a very informative indicator. Does anyone know why it isn’t making new highs even though the stock market is hitting all-time highs and corporate profits are flat to down?

https://fred.stlouisfed.org/series/A053RC1Q027SBEA

[ertyu]

This makes sense to me from a psychological standpoint, if the overall investment strategy is along the line of J.L Collins The Simple Path to Wealth. Anyone following this strategy will not sell no matter how one discounts their portfolio. So it's just a mental preparedness exercise.

There has been no prolongued correction for a long time, so I think many people overestimate both their own likelihood to stick to a strategy and other people's likelihood to stick to a strategy. Once the numbers start falling right in front of your eyes, the effect is visceral. I predict more people should sell than expect it of themselves or than "are generally expected."

[classical_Liberal]

Does anyone know why it isn’t making new highs even though the stock market is hitting all-time highs and corporate profits are flat to down?

Yes, PE took a huge hit in the wake of the financial crisis as companies were forced into accounting adjustments. Those really, really bad quarters fell off the CAPE as it's been ten years now. IOW, the "CA" in CAPE isn't valid presently, because we haven't seen a significant downward cycle in the last 10 years. OTOH, some would argue those quarters of really bad PE's were artificial.

I think many people overestimate both their own likelihood to stick to a strategy and other people's likelihood to stick to a strategy. Once the numbers start falling right in front of your eyes, the effect is visceral. I predict more people should sell than expect it of themselves or than "are generally expected."

I tend to agree with your sentiment. I'm just not sure hypothetically correcting a portfolio will change anyone's mind though. Unless someone has really never considered the ramifications of different macro economic variables. I doubt there are many of those folks here.

[Laura Ingalls]

Laura: The wealth effect is, you think you're richer than you are, so you spend more than you can actually afford because your brokerage account balance says you can. Thus correcting for the wealth effect would be, "the number here might say 100k, but in actuality, it is 58k and I should spend accordingly. I imagine that's the point of this exercise.

Other than that, yes: it is sequence of returns/initial amount

I get that but I just don’t think it is just this enormous temptation for most on this board (especially Jacob with his 100 times expenses combined with his dislike of travel and restaurants).

I think the bigger risk with the current run up is that someone just barely gets to 25x expenses and then the market tanks. I have used part time employment as my buffer from both underestimating expenses and market pullback. Later my pension and social security will play that role.

[black_son_of_gray]

I know for a fact, some here, like @BSOG and @MI, put their money where their mouth is, so to speak.

Gather round folks while I finish putting on my tinfoil hat.

I have in fact sold completely my stake in US stocks (VTI). I still have long term bonds (TLT), gold, and cash/cash-like investments. Was I trying to time the markets? Meh. Was I trying to lock in realized gains? Ding! Did I want to be more liquid and safe because I'm looking to buy property and move within a relatively short time frame from now? Ding! Was I able to do it in a relatively tax-friendly way? Ding! Were CD rates higher than the market's dividend anyway? Ding! Did the prospective ~10 year returns on the market look abysmal compared to the risk? Ding! Does this mean you should sell too? Not my call.

Could I miss out on the Federal Reserve prestidigitating another +30% year? Yeah, I suppose I could. I'm ok with that. Frankly, I'd be impressed .

Lots of economic/market data look... precarious. (Which is part of the point of @jacob's OP) Add into that an active impeachment process, an election year the outcome of which could dramatically influence markets, and a president who casually shoots from the hip without aiming. Politics is moving markets more these days than I am comfortable with. Do I know what will happen to various asset classes? No. Will I buy US stocks in the future once my living situation is settled and the market looks favorable? Sure. (Can I still be a doomer if I'm not convinced of "doom"?)

God that tinfoil makes my head sweat.

[classical_Liberal]

@BSOG
I didn't mean to say you were a doomer, or deserved a tin foil hat (for this at least ). What I mean is that there are plenty of reasons to have stocks in a portfolio, and with current valuations plenty of reasons not to, particularly if one's present personal lifestyle risk profile fits into that picture (again I'll state, the later is a component most people seem to miss when choosing how to invest, what does your personal risk situation look like?). My point is, what you did makes perfect sense. What doesn't make sense to me, is to risk adjust a portion of my portfolio to 50% present value, to a mean reverted state or however you want to calculate it, without taking action.

If I was fairly certain there was a 50% mean reversion coming to a big chunk of my portfolio, I'd find the quickest, most tax efficient way to harvest my gains and get out! Not just throw my hands in the air and divide it by two so I don't "feel" too rich. That seems like a foolish exercise in futility. If someone is committed to having a portion of stocks in their portfolio "no matter what", because we aren't "sure". It's much better to simply extrapolate what's actually correlated to high CAPE. Lower 10 year returns on that portion of your portfolio.

[black_son_of_gray]

@c_L: gotcha, and I agree that in the end there is only what we do. This is when I remove the tinfoil from the recycling bin, place it back on my head, and admit that if my personal situation (buying property, moving, etc.) were different, I'd probably still have sold off my VTI... but my circumstances being what they are definitely made it easier to make the call.

[IlliniDave]

... I'm still expecting < 2.5% pa real return on a 60/40 portfolio over the next 15 years.

If anyone cares, I had a chance to refresh the numbers last night and the current estimate* calculation is 1.8% pa real on a 60/40 portfolio over the next 15 years.

*If you write this estimate on a $5-bill, the bill will be worth about $3.

[ertyu]

Hussman estimates 0.3% per yr nominal on 60/40 over the next 12 yrs. All estimates not good. What would really surprise everyone at this point is if stocks don't drop. While I'm personally not brave enough to put my money where my mouth is, it seems to me QE and other magic will continue until valuations fall not because of a nominal drop but because increased inflation has caused them to decrease in real terms. Followed by another rally as the debt is inflated away. If you manage to keep your population fed through further magic like MMT/MonPol III, this just might work.

[Seppia]

Hussman estimates 0.3% per yr nominal on 60/40 over the next 12 yrs.

Hussman has also been spactacularly wrong for a full decade though, I'm not sure I'd turn to him for reliable forecasts

This doesn't mean we should not expect future 10 year returns to be on the low end of the historic averages, as it is a simple matter of regression to the mean

[George the original one]

Just to make one more point relevant to the OP. If we are, in fact, in a situation where we should be discounting our portfolios by 25% or more, isn't now the time we should spend more?

I'll make the case that one shouldn't spend more just because there is more to spend. Partly because local costs usually rise to meet the rising asset prices and partly because you can't predict when and by how far the assets will fall.

I'll temper that stance, however, that if one sees a better than normal deal, then now is the time to pounce (e.g. buying British or Canadian goods with US dollars when the US dollar has gained significant strength). Ideally though, outside of living expenses, one should not be spending their capital on non-productive assets; you might consider taking profits and/or re-deploying assets to rebalance the portfolio.

[classical_Liberal]

Ideally though, outside of living expenses, one should not be spending their capital on non-productive assets; you might consider taking profits and/or re-deploying assets to rebalance the portfolio.

It depends what you mean by productive assets. Not everything is financial in nature.

I am going to take a risk and write a book, I know I need to purchase six months of my time to complete this task at a cost of about 10K. This book may never sell a copy, or it may start a movement and generate living expenses for the next decade. Could go either way, but it's something I need to do, it's only a matter of when. I saved the 10K in a productive asset called VTI and today's market value of that is 13K, but I believe it to be inflated. Am I better off selling the asset and writing the book today, or waiting until I feel the asset to be fairly priced at 10K?

partly because you can't predict when and by how far the assets will fall.

If one is discounting asset values by 25%, then you are already assuming some level of knowledge to predict the long term value of that asset. You can't have it both ways. ie I'm discounting an asset because I believe it to be overvalued, and I don't know what the asset is worth. If you're really relatively clueless, you should not discount the value and this exercise is mute.

Partly because local costs usually rise to meet the rising asset prices

The S&P500 returned 30% last year and the latest inflation number for the US was 2.1%. I'd say, in general, local prices have not risen in line with asset inflation.

I'll temper that stance, however, that if one sees a better than normal deal, then now is the time to pounce (e.g. buying British or Canadian goods with US dollars when the US dollar has gained significant strength).

Yes, if you can get something at discounted value by trading an overvalued asset it's a no-brainer. I'm arguing that that it's also a no-brainer to get a fairly valued asset by trading an overvalued asset. I'm not arguing to change your plans from buying a 2010 toyota to a 2019 BMW, just that if one believes liquid assets are overvalued and they are eventually going to buy the Toyota, now's the time to do it.

[Lucky C]

Jacob used the historical median CAPE10 to scale equities which is perfectly fine for a quick and easy rough estimate, but if you want better accuracy I think there are a couple ways to improve upon it.

If you want to use multiple valuation measures so you don't rely only on the CAPE, you can follow dshort's monthly updates on market valuation. Just updated today for December's ending values. Here you can see the Crestmont P/E, CAPE10, and Tobin's Q ratio vs. their historical averages, as well as the S&P Composite vs. its regression to the mean. While the CAPE10 is 82% above its historical average (16.7 mean instead of the 15.76 median referenced by Jacob), the average of the four factors is 126% above the historical average. That means that if your equities are a collection of US stocks at a collective valuation that is close enough to the broad market, you'd want to divide your equities balance by 2.26 to remove the paper wealth effect and see how much you would have if stocks dropped to historically average valuations tomorrow. That's a reduction of 56%.

Alternatively, if you want to use a single valuation metric that has higher correlation to long term (10-15 year) returns than the CAPE, you could use a longer earnings lookback (CAPE15 or CAPE20...), or refer to Hussman's Non-financial Market Cap to Non-financial Gross Value Added, which I believe he has successfully demonstrated has better correlation to subsequent 12-year returns than CAPE10. Based on the 7th chart here, the stock market's around the 2.3x level, which is a good match to the average of the valuation metric mentioned above.

I would bet Jacob's portfolio would have a more reasonable valuation than the broad market, plus he's not 100% in equities, so the -25% reduction to get rid of the illusion of paper wealth might make sense for him. But for a 100% US portfolio (especially if S&P500 index), -50% to -60% is more appropriate.

[Quadalupe]

One year later, the value for S&P 500 has decreased to 15.81/38.54=41% of market price. Where does it end...

Sources:
https://www.multpl.com/shiller-pe for current median shiller p/e
https://www.multpl.com/s-p-500-pe-ratio/table/by-year for current p/e ratio of S&P 500

[2Birds1Stone]

One year later, the value for S&P 500 has decreased to 15.81/38.54=41% of market price. Where does it end...

How about against a 60/40 portfolio? (which for reference was 58% a year ago).

[Quadalupe]

Well, if we look at the 10Yr Treasury rate now, it's 1.119% (per https://www.cnbc.com/quotes/?symbol=US10Y).

The value of a 60% S&P500 and 40%10Yr Treasury portfolio currently is 0.6*15.81/38.43 + 0.4 * 1.119/3.84 = 36%. Over 20 percent points lower than a year ago.