Rajiv Sethi, a professor of economics at Barnard College, Columbia University, said in a blog entry update dated February 17, 2010, that: “Rob Bennett makes the claim that market timing based on aggregate P/E ratios can be a far more effective strategy than passive investing over long horizons (ten years or more.) I am not in a position to evaluate this claim empirically but it is consistent with Shiller’s analysis and I can see how it could be true.”
Schroeder (a regular at the Goon Central board) put a comment to that blog entry that night describing a case in which he believes that Buy-and-Hold produced better results than Valuation-Informed Indexing. I disputed this point, arguing that Schroeder’s illustration was cherry-picked after-the-fact and that The Investor’s Scenario Surfer shows that Valuation-Informed Indexing produces better long-term results in roughly nine out of 10 of the possible returns sequences. I asserted that a strategy that produces good results in only one out of 10 of the possible scenarios is a high-risk strategy and that, thus, it cannot be said that Buy-and-Hold is providing good risk-adjusted returns even in those few cases in which it yields better nominal results than Valuation-Informed Indexing.
Sethi offered the following comments in response to my post:
“Rob, I don’t think that randomly generated returns (regardless of the distribution you are using) can provide a convincing test of your claim. What you would need to do is to use historical data (as Schroeder has done) with multiple starting points and horizons. But even this is not enough: the P/E thresholds you choose for switching portfolio composition must be such as to generate on average over time the same asset allocation as the buy and hold strategy. In other words, you can’t pick the critical P/E thresholds (12/20) and the asset allocations (25/50/75) independently: they have to be selected jointly to match the buy and hold asset allocation over long horizons.”
I posted a lengthy response, which I encourage you to read by following the link set forth above.
I am grateful to Sethi for sharing his thoughts with us. I believe that he has pushed the ball forward a bit. That Schroeder individual I am not so sure about (I’m joking — there have been numerous cases in which Schroeder has offered constructive comments and this is one of them, in my assessment).