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What? Are you Madoff? These days, anything related to 'low risk' or 'steady' returns generates skepticism. It is very understandable and perfectly reasonable for investors to have such a feeling, given what have happened in the financial industries.

However, if an investor does follow sound and safe investment principles consistently and disciplinarily, yes, Virginia, there is a hope! In the following, we will show how one could achieve a 10% return in the past 9 years by simply incorporating Buffett or Shiller long term stock market timing indicators in your investing.
The idea is simply that, when the stock market is significantly undervalued, one should fully invest in the stock market; when the stock market is significantly overvalued, one should sell the stocks and fully invest in bonds using some fixed income strategies. The proxy to invest in stock market is Wilshire 500 total return index while the strategies for fixed income investment are Alpha Dynamics for Multi Sector Bonds. This strategy evaluates 32 multi-sector bond mutual funds every quarter based on their trailing one year's Alphas and then select top 3 three funds for next quarter investment. The quarterly rebalancing frequency allows investors to avoid the short term redemption fee charged by brokerages or fund companies. It switches to Cash (13 week treasury bill) when none of the funds has positive 1 year alpha.

The following table illustrates the performances for the two portfolios from 12/31/2000 to 11/20/2009.

	Annualized Return	Standard Deviation	Maximum Drawdown
Buffett Indicator based Bond as Cash	12.73%	1.21	11%
Shiller Indicator based Bond As Cash	10.38%	11.1%	20%
Wilshire 5000 Total Return	-0.58%	22.2%	56.6%

A portfolio with much longer history (from 12/31/1990 to 11/20/2009) using Shiller's metric and alpha based high yield bond fund quarterly switch strategy shows a similar result (9.75% annualized return).

The above are just some of examples to show that if one is patient enough and avoids the hype in a long term period, he/she will be rewarded with  low risk reasonable returns.

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John Hussman, manager of Hussman Strategy Growth Fund (HSGFX) proposed price to peak 10 year average earnings as a long term stock market valuation gauge. Compared with the normal one year price to earning ratio, Price to Peak Earnings would eliminate short term noise. This is similar to Shiller's Cyclically Adjusted Price Earning ratio (CAPE10) and Warren Buffett's stock market GNP/GDP metric. In his weekly commentary on Dec 5, 2005, titled as 'Earnings Revert to the Mean, Stocks Will Struggle', he proposed a simplistic method: "buy when Price to Peak Earnings is lower than 15 and sell when it exceeds 19.5". John Hussman has been using this as the valuation yardstick to manage the Hussman Strategic Growth Fund HSGFX.
It is interesting to examine how effective using such a metric as a long term stock market timing indicator. Similar to the Warren Buffett's stock market GNP/GDP metric and Shiller's CAPE, the following strategy characterizes the stock market valuation into the following five categories based on the ratio of the current Peak PEs to the long term average Peak PEs:

• Significantly Overvalued (SO): such as if the ratio >= 150%
  
• Modestly Overvalued (MO): such as if   117% <=  ratio < 150%
  
• Fairly Valued (FV): such as if 83% <= ratio < 117%
  
• Modestly Undervalued (MU): such as if 67% <= ratio < 83%
  
• Significantly Undervalued (SU): such as if ratio < 67%

These five categories are determined by four valuation parameters (such as 150%, 117%, 83% and 67% in the above). At each rebalancing (adjusting) period (such as weekly or monthly), the strategy decides at what region 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 like only buying at significantly undervalued (SU) level and selling at significantly overvalued (SO) level. Some of model portfolios of this strategy are:

• SO: >=150%, MO: [117%, 150%), FV: [83%, 117%), MU: [67%, 83%), SU: <67%
  
• SO: >=150%, MO, FV, MU: [67%, 150%), SU: <67%

A model portfolio called P Hussman Peak PE Market Timing Strategy Buy 15 Sell 19.5 Weekly is also maintained to live monitor the strategy suggested in 'Earnings Revert to the Mean, Stocks Will Struggle'.
The following table compares the performance of the three long term stock market indicators. All of the portfolios are based on 'buy at significantly undervalued and sell at significantly overvalued' strategy.

	12/31/1970 to 11/13/2009
Buffet GNP Metric Annualized Return	9.74%
Shiller CAPE10 Annualized Return	6.9%
Hussman Peak PE Annualized Return	8.02%
Wiilshire 5000 Total Return Annualized Return	6.9%
Buffet GNP Metric Sharpe Ratio	0.53
Shiller CAPE10 Sharpe Ratio	0.25
Hussman Peak PE Sharpe Ratio	0.33
Wilshire 5000 Total Return Sharpe Ratio	0.15

All of the strategies have achieved better returns and much higher Sharpe ratios compared with Wilshire 5000 total return index.

On Friday 11/13/2009, Both Buffett and Hussman metrics indicated the market was fairly valued: Buffet Total Stock Market Valuation to GNP ratio was 78.6% while Hussman's Peak PE10 to the long term Peak PE10 average was 1.04 (current peak PE 10 was 12.4 and the long term average was 11.9). Shiller CAPE10 to its long term average indicates the market was 22% overvalued.  It should be noted that John Hussman has been very cautious recently, pointing out the uniqueness of the current economic situation. Interested readers should read his latest weekly commentary here.

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 (Correction: this article is corrected version from the previous one published on 10/23/2009. In the previous artilce, we used nominal PE10 instead of real PE 10, that resulted in higher PE10 ratio, which is incorrect).
Yale Professor Robert Shiller has devised and maintained a so called "Cyclically Adjusted Price Earning Ratio" (CAPE10) as an alternative to the popular PE ratio to value the US stock market. CAPE10 is defined as the ratio of price to the average of last 10 year trailing S&P 500 annual earnings. In his now famous book titled as "Irrational Exuberance", Shiller popularized this ratio as a long term stock market valuation metric.  As it stands on last Friday October 30, 2009, the current CAPE10 is 18.88 while the long term average CAPE10 (since year 1881) is 16.38. This implies that the current US stock market is 16% over valued.

It is interesting to examine how effective using such a metric as a long term stock market timing indicator. Similar to the Warren Buffett's stock market metric, ValidFi implements and maintains a live strategy called Shiller Cyclically Adjusted PE 10 Stock Market Timing Strategy. One of its model portfolios buys stocks only when this ratio is deemed to be significantly under valued (the current CAPE10 is 33% lower than the long term CAPE10 average) and goes into cash when such as ratio signals significant over valued (if the current CAPE10 is 50% higher than its long term average). The stock market exposure is through buying Wilshire 5000 total return index (^DWC).

From 12/31/1970 to 11/2/2009, the weekly adjusted portfolio achieves 6.8% annualized return and standard deviation 11.9% compared with Wilshire 5000 total return's annualized return 6.77% and standard deviation 19.5%.  Such a portfolio was in cash from 5/12/1995 all the way to 2/20/2009! See the following chart:




It is hard to believe that an average investor would have such patience to stay out of the stock market for such a long time, especially during the bull markets. However, a prudent investor would utilize such an indicator to carefully manage the risk during over valued periods.

Some readers might ask that since Shiller's indicator is a long term indicator, what strategies one could use during the long time periods when it is out of stock market. We will have follow up articles on how to combine such a long term indicator and some safe strategies to achieve safe and more reasonable returns.

Interested readers could find the up to date information of both Shiller and Buffett indicators on ValidFi's 360 Degree Market View page.

Labels: ^DWC, BWX, CFT, EEM, EFA, IWM, MDY, Portfolio_7018, SPY, Strategy_629, TLT, VFINX, VTSMX