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In his 2001 Fortune magazine article, Warren Buffett used the ratio of the market value of all US publically traded securities to Gross National Product (GNP) as a yardstick to measure the stock market valuation. He stated that  

"The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment".

He further went on to say

"If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%--as it did in 1999 and a part of 2000--you are playing with fire".

Such a simple yet elegant metric (we call it Buffett Stock Market Indicator) could be implemented in several ways. At the moment, ValidFi maintains a strategy called Warren Buffett Total Stock Market Value to GNP Ratio Strategy. This strategy characterizes the stock market valuation into the following five categories: 

• Significantly Overvalued (SO): such as if the ratio >= 115%.
• Modestly Overvalued (MO): such as if   90% <=  ratio < 115%.
• Fairly Valued (FV): such as if 75% <= ratio < 90%.
• Modestly Undervalued (MU): such as if 50% <= ratio < 75%.
• Significantly Undervalued (SU): such as if ratio < 50%

These five categories are determined by four valuation parameters (such as 115%, 90%, 75% and 50% in the above). At each rebalancing (adjusting) period (such as weekly or monthly), the strategy decides at what category the US stock market valuation is and then does the following rebalancing:

• SO: 0% in stock, 100% in cash.
• MO: 25% in stock, 75% in cash.
• FV: 50% in stock, 50% in cash.
• MU: 75% in stock, 25% in cash.
• SU: 100% in stock, 0% in cash.

The stock market exposure is through buying Wilshire 5000 total return index (^DWC) or it could be set by users. Users could adjust the valuation parameters to get an effect such as only buying at significantly undervalued (SU) level and selling at significantly overvalued (SO) level. Some of model portfolios of this strategy are:

• SO: >=115%, MO: [90%, 115%), FV: [75%, 90%), MU: [50%, 75%), SU: <50%.
• SO: >=115%, MO, FV, MU: [50%, 115%), SU: <50%.

The total US stock market valuation is based on Wilshire 5000 index while the GNP is based on Federal Reserve's quarterly released number. From 12/31/1980 to 9/18/2009, the weekly adjusted portfolio achieves 8.648% annualized return and standard deviation 12.2% compared with Wilshire 5000 total return's annualized return 7.4% and standard deviation 17.5%.

It is even more amazing if an investor opted to invest only when the market was significantly undervalued and went to cash when the market became significantly overvalued. Such a strategy would keep an investor in cash from 2/27/1998 to 3/6/2009: avoiding the last two bubbles altogether!  The following figure shows the transactions:

Such a portfolio achieves annualized return 9.71% with standard deviation 11.4% from 12/31/1980 to 9/18/2009. There are only 3 transactions during this whole 29+ year period.

On last Friday (9/18/2009), the Buffett Indicator stood at 77.5%,  valuing the US stock market as Fairly Valued if one uses the 5 categories above.

Along with Buffett Indicator, ValidFi recently introduced various financial, economic and sentiment indicators. Interested readers could find up to date information of these indicators on ValidFi's 360 Degree Market View page.

Labels: BWX, CFT, DBC, EEM, EFA, GLD, IWM, IYR, JNK, LQD, MDY, PCY, Portfolio_6511, Portfolio_6517, QQQQ, SPY, Strategy_613, TIP, TLT

With summer fading away, we now suddenly find ourselves in September, one of the worst months for the stock market. It is thus a good time to check up your portfolio and make necessary adjustments if it is necessary.

In the previous article, we introduced ValidFi's Guru Asset Allocation Watch and strategies. The Guru Asset Allocation Clone strategy applies ValidFi's proprietary algorithm to detect a mutual fund's asset exposure and utilizes the derived information to make necessary asset allocation decision for each month. The risk adjusted performance of the strategy is fairly impressive for the past ten years. Readers could examine one of its model portfolios for more information.

The portfolio recently made a noticeable asset allocation change on August 31st. 2009. The following table compares its August and September allocations (notice that the funds used to represent the asset classes could be replaced by ETFs such as SPY, EFA, IYR, TIP, CIU or CFT, BWX, EEM, HYG or JNK and BND or AGG).

Asset	August Allocation	September Allocation
VBMFX	0.00%	0.00%
VFISX	20.47%	0.00%
VWEHX	0.56%	2.31%
VEIEX	3.50%	5.08%
TGBAX	10.25%	0.00%
VFICX	15.09%	46.52%
VIPSX	10.80%	27.98%
VGSIX	0.03%	0.06%
GLD	0.00%	0.00%
VGTSX	2.96%	1.96%
VFINX	36.34%	16.08%
Stock Exposure	42.83%	23.18%

From the above table, the most noticeable changes are:

• Total stock exposure: reduced from 42.83% to 23.18%
• Fixed income allocation: big increase to Investment Grade Corporate Bond (VFICX) and Inflation Protected Treasury Bond (VIPSX)

The September allocation is very defensive.

Let us further examine the recent allocation moves for several top performing allocation funds.
The following picture illustrates Vanguard Wellesley Income Fund (VWINX). We could see the fund made noticeable reduction in equity exposure during August.



The other top allocation fund, GMO Benchmark-Free Allocation GBMFX has the following allocation trend:



Again, the fund made equity reduction during the August time frame.

Readers are encouraged to take advantage of the ValidFi's Real Time Asset Allocation tool to find out asset allocation trends of your favorite funds. It is free but requires a registration during its Beta testing period.
To summarize, several great asset allocation investors have made a very defensive move. Even if you don't want to change your asset allocation right now, it pays to keep an eye on this.

Labels: BWX, CFT, CIU, DBC, EEM, EFA, GLD, HYG, IWM, IWN, IYR, JNK, LQD, MDY, PCY, QQQQ, SHY, SPY, TIP, TLT

On August 28, 2009, seekingalpha.com. Amid the euphoria on possible economic recovery, most major stock and debt markets have risen in an almost nonstop fashion since June of this year. This presents a heightened anxiety among many prudent investors: will there be another leg down if the rosy picture about the economics turns out to be premature? Read more ...

Labels: EEM, EFA, IWM, IYR, portfolio_6303, portfolio_6305, QQQQ, SPY, strategy_509, XLB, XLF, XLI, XLK, XLP, XLU, XLV, XLY