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Market valuation using MZM

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Hi Cullen,

I’d like to ask you your opinion on assessing market valuation by comparing it to available supply of money (like this: https://fred.stlouisfed.org/graph/?g=fKOR). Assumption behind is that in long term, similar proportion of available funds are allocated to the stock market.

In your speech at Vegas, you said that US stock market is terribly overvalued. Using this indicator, stock market would have to fall about 15% to go back long term median of cca 1.5. Overvalued, but probably not terribly. Still below 2007 level.

I know it will crash at some point in future – I’m more concerned about possible long-term returns at current valuation.

Using Stock/MZM is not my idea, but I find it very intuitively appealing. But I also highly value your opinions.

P.S. Excuse my English, I’m from Czech Republic.

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Posted by (Questions: 1, Responses: 1)
Posted on 11/16/2017 5:25 PM
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Hi Zbynek,

Your English is great.

There’s a lot of ways to value the market and your metric is perfectly rational. You have to be careful with valuation metrics though. A lot of people will use these metrics and conclude that they should be all in or all out of the market. But this isn’t a binary decision. It should exist more on a scale. That’s why I am an advocate of Countercyclical Indexing. So, for instance, with valuations at an elevated level your assumption is that future returns will be lower on a risk adjusted basis. So you might be underweight stocks relative to what you otherwise would be. For instance, if you’re young and aggressive maybe your baseline allocation to stocks is 75%, but in a market like this maybe you’re 60% or 50%. Underweight to account for the higher risk in stocks, but not making the mistake that so many people do by moving all in or out and treating it like a binary output.

But at the end of the day you need to understand your own profile and apply the proper allocation within those parameters. Unfortunately, it’s impossible for me to do that for you without knowing you. Although I would love to visit CR again and drink some Czech beer with you! 🙂

Make sense?

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Cullen Roche Posted by (Questions: 10, Responses: 1800)
Answered on 11/16/2017 10:20 PM
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Hi Cullen,

thanks a lot for your response. Yes, it definitely makes sense. In fact, I find your Countercyclical Indexing also very intuitively appealing – to the point that I’m wondering if I could do something like that myself. I perfectly understand that you do not disclose details of how you implement the strategy. And given the circumstances, it is unlikely that I’ll become your client. So, if I decide to use your ideas, it would be at my own risk.
I’ve read your paper as well as referenced documents on Risk Parity and Adaptive Asset Allocation. And if you could comment on the statements below (that represent my current understanding) it would be great.

1. Goal of CC indexing is to keep risk of the portfolio (or risk-adjusted return) at target level.
2. It achieves it by altering allocations of portfolio assets based on current state of the market.
3. Similar to Risk Parity approach, assets are selected to counterweight each other in times of stress. What is important is behavior of each asset in different phases of the market cycle.
4. Adaptive Asset Allocation as proposed by Sharpe is actually procyclical – asset allocation follows market movements.
5. Traditional approach with rebalancing to fixed allocations (what I do now) is contrarian in nature, because it shifts funds from winners to loosers (or from riskier to less risky, depends on how you look at it). This improves risk-adjusted returns, but portfolio as a whole still gets riskier when stock market booms.
6. CC indexing goes further in this approach, so it is even more contrarian than traditional approach. From AAA, it takes the idea of adaptive allocations, but not in the way suggested by Sharpe. Rather, it shifts allocations in the opposite direction to return risk of the portfolio to its original target.
7. Core asset classes to consider are US stocks, Ex-US stocks, Long and Mid-term US Government Bonds.

thanks in advance, Zbynek

P.S. It is quite possible that I will finally decide that this way over my head and that I’ll be better served sticking to simple fixed-allocations approach, using what I learned from you to carefully select the assets. Still, it is very entertaining and enriching endeavour.

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Answered on 11/17/2017 11:06 AM
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Hi Zbynek,

Sorry for the slow response.

1) The goal of CC is to create better balance between the risks that the assets in your portfolio expose you to. In this sense it’s very similar to Risk Parity.

2) CC Indexing can respond to any benchmark you set. I don’t disclose how I do it because that’s pretty valuable intellectual property to me, but you could use a lot of different approaches.

3) Yep.

4) Yep. In fact, I’d argue that most index fund strategies are procyclical. Even the S&P 500 is procyclical.

5) Traditional indexing is contrarian and countercyclical to SOME degree, but I would argue not enough. For instance, if 60/40 grows to 70/30 then rebalancing back to 60/40 could be rebalancing to a riskier 60/40. In other words, it’s not counteryclical enough….

6) Yep.

7. Yeah, you could add in anything. I keep it simple and use global stocks and bonds and tilt the bond duration piece across time to account for added interest rate risk. My approach is actually two strategies in one because I run the full portfolio in a countercyclical manner AND I run the bond piece in its own duration switching CC approach. But again, you could skin the cat a million different ways by adding other asset classes, etc.

Simple is usually better in this business so don’t sweat it if you end up at the simplest conclusion. To each his own. Just remember to establish an appropriate plan (avoid the search for the perfect plan) and keep it low fee, tax efficient, and diversified.

Good luck!

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Cullen Roche Posted by (Questions: 10, Responses: 1800)
Answered on 11/20/2017 4:39 PM