Allow for Investment Portfolio Adjustments to Suit the Times

By Russell Wild

One of the few constants in the world of investing is the tendency for investment returns to revert to their mean. What this means is that if a particular kind of investment (stocks, bonds, what-have-you) typically returns X percent a year, but for the past several years has returned considerably more than X, you have a better than 50/50 chance that the returns are in for a slowdown.

If, conversely, the investment has been producing returns in the past several years far less than X, you have a better than 50/50 chance that the returns are about to improve. This rule, appropriately enough, is called reversion to the mean.

Stock returns are popularly calculated by what is referred to as the P/E ratio. The “P” stands for price. The “E” stands for earnings. When the average price of all stocks is divided by the average earnings of all companies, you typically come up with a number somewhere around 20. In other words, if the average price of the average stock is $10, then companies are by and large making about 50 cents a year for every share of stock they’ve issued.

Studies going back decades show that whenever the P/E has risen far north of 20 (such as it did in 1999), stock returns usually start to sputter, and they sputter for a good while. When the P/E drops far below 20 (as it did in 2008), stock returns usually heat up for the next few years.

Not long ago, a Yale economist named Robert J. Shiller adjusted the P/E to reflect not only earnings of the past year (as the P/E typically measures) but earnings over the past 10 years, taking inflation into consideration. Testing of the data seems to indicate that the Shiller P/E (the P/E ratio is often called the multiple) may be a somewhat more accurate predictor of future stock performance than the old-fashioned P/E. (This topic is currently an area of hot debate.)

The old-fashioned P/E ratio is published in many places. Search for the Vanguard Total Stock Market ETF (VTI), and check the current P/E ratio in the fund’s description. Click on the “Portfolio & Management” tab. The P/E was about 21, slightly above the historical norm. The Shiller P/E, however, was riding at about 20.5, well above its historical mean of 15.5.

If you look at non-US stocks (go to Vanguard again and instead of checking VTI, check the Vanguard Total International Stock Market ETF [VXUS]), you’ll see that the P/E ratio for foreign companies is currently 19. Unfortunately, there is no one at present tracking the Shiller P/E of foreign stock markets.

You don’t want to go crazy with this stuff, but if the P/E ratios above were to fall well behind historical norms, it may be a good time to beef up on stocks . . . perhaps adding 5 percent or so to your normal allocation. If the ratios rise well above historical norms, you may want to beef up on bonds . . . perhaps taking your normal allocation up 5 percent and reducing your stock holdings accordingly.