How I Handle High Stock Prices in My Portfolio

The best way to respond to stock market news is usually to ignore it.  This is (almost) what I do.  The exception is that I make small adjustments when stock prices are very high.  David Chilton asked me about these adjustments when he interviewed me for his podcast.  Here I give a fuller answer to his question.

I hesitate to talk too much about this part of my portfolio plan, because it is a small step toward market timing, and investors get themselves into a lot of trouble with market timing.  I once described how I handle high stock prices to a friend, and he responded by selling all of his stocks.  The change in my own stock allocation percentage was barely noticeable, but he had gone to zero, mainly because I caused him to think about high stock valuations.  This was definitely not the outcome I wanted.

Most sensible people avoid market timing.  I used to be one of them.  But I realized that I was against market timing unless something really crazy happens that I never anticipated.  For example, if some future government were to threaten to nationalize large public corporations without compensation to owners, most investors would think hard about their stock ownership.  

Most investors treat extremely high valuations as a problem to worry about if it ever happens. Some people who advocate sticking with an asset allocation through thick and thin would change their minds if world stock prices were to climb to the levels we saw with Japanese stocks in 1989.  In such a case I would sell some of my stocks.  I decided to figure out in advance how I’d respond to stocks becoming increasingly more expensive.

My portfolio rules are all coded into a spreadsheet.  A script runs each day to see whether my portfolio needs rebalancing.  Most of the time, I don’t need to pay any attention.  If the script thinks I need to make some rebalancing trades, it emails me.  If I could figure out how I would respond to high stock prices, I could automate that in the spreadsheet and script.  I’d have even less reason to pay any attention to markets.

CAPE

Before deciding how to respond to high stock prices, we need some way to define how high stocks are.  Robert Shiller’s Cyclically Adjusted Price-to-Earnings ratio (CAPE) does this job.  The CAPE is just the current price divided by the average inflation-adjusted earnings over the past decade.  The CAPE for U.S. stocks is widely-reported.  As I write this, the U.S. CAPE is at about 41.

I’m more concerned with the CAPE across all of my stocks across the world.  This blended CAPE is at about 34 as I write this.  If I was certain the CAPE wouldn’t go much higher than this, then I wouldn’t bother with any form of market timing.  But I want my spreadsheet to respond reasonably to extreme CAPE levels no matter how unlikely they are.

Future stock prices

Before considering any market timing, I wanted to decide how a high CAPE would affect future expected stock returns.  The answer is that it has a modest effect.  When the CAPE is high, future stock returns tend to be a little lower.  The effect is far too weak to justify jumping all the way in and out of stocks, though.

I came up with a simple rule.  When the CAPE is above 20, I assume that the CAPE will return to 20 by the time I reach age 100.  A simple calculation figures out how much stocks will underperform each year for them to drop from the current CAPE level to 20.  This is currently about 1.5% per year.  So, I take my usual expected annual stock return and reduce it by 1.5%.  My spreadsheet uses this reduced expected stock return to calculate my safe monthly retirement spending amount from my portfolio.

Interestingly, this approach tends to smooth out my monthly safe spending level.  In the short term, when stocks rise, it drives the CAPE up.  The higher stock prices push my safe spending level up, but the higher CAPE pushes my spending level down.

Variable Asset Allocation (VAA)

When the CAPE is not high, my bond allocation is equal to 5 years of my safe spending level.  At my current age, this works out to about 22% bonds and 78% stocks.  This feels like a reasonable allocation when the CAPE is below about 25 (I mistakenly said 30 in the podcast interview).  During the dot-com runup, the U.S. CAPE reached 45.  What if world stocks reach a CAPE of 50?  I decided I’d want my stock allocation to drop to about 50%.  What if the CAPE reaches 75?  I decided I’d want my stock allocation to drop to about 25%.

To roughly match these decisions, I use the following simple rule, that I call Variable Asset Allocation (VAA).  When the world CAPE exceeds 25, I subtract 25 from the CAPE and add this number of percentage points to my bond allocation.  With my portfolio’s CAPE at about 34, this adds 9 percentage points to my bond allocation.  So, instead of having a stock/bond mix of 78/22, I have 69/31.

As we can see, even at the lofty levels of current stock markets, my portfolio shift is modest.  It’s only if world markets move into territory never seen before that my portfolio will make larger shifts away from stocks.

Risk control

My reason for baking VAA into my spreadsheet is to control risk.  If stocks ever reach even crazier heights, I will be wealthier and will have less need to take risks to meet my retirement goals.  The fact that I could have been even wealthier by staying invested heavily in stocks is of little concern to me.

I’m more concerned about preserving wealth if stocks drop from unprecedented levels back down to more familiar levels.  In normal times, a 30% drop in stocks is likely enough to think about.  At current stock prices, this is more like a 40% decline.  If stocks keep rising, the possible decline grows.  We don’t know when or by how much stocks might crash, but I want to strike a reasonable balance between preserving wealth in a crash and growing wealth over time.

How has VAA worked out for me?

As markets fluctuate, my portfolio rebalancing (that incorporates VAA) makes small amounts of money compared to not rebalancing at all.  However, the dominant direction for the stock market has been up for many years now.  Since I added VAA, it has cost me money.  However, if stocks ever crash, VAA will suddenly save me a lot of money.

I don’t recommend any of this to others.  I thought about these matters long enough to implement them in a spreadsheet and script.  I can’t imagine what it would be like to do these calculations daily without full automation.  My portfolio management feels simple to me, because I can ignore it for months at a time, and then just do whatever the script’s email tells me to do.

For more discussion of VAA, see this article.