Previously we detailed a framework to develop mid-term expectations. Now we’ll look at utilizing these expectations with a dynamic asset allocation approach to create cumulative alpha over two full market cycles (backtest xls included).

Stock gains come in the form of cumulative gains via cycles driven by the trend in the P/E Ratio.

This is why focusing on cycles and P/E trends is critical.

By utilizing the 10 year cyclically adjusted P/E (CAPE), we can make shifts to more efficient allocations to improve cumulative asset gains.  Efficiency = Return/Risk.

To read the previous posts on developing mid-term expectations go to -

• Asset Allocation Practice – Developing Mid-Term Stock Return Assumptions
• Asset Allocation Practice – Enhancing Our Traditional Approach with a Mid-Term Perspective

Below is an example of when stocks were at their highest valuations ever. The dynamic approach shifts a long-term moderate allocation strategy (26% Efficiency) to the conservative allocation (85% Efficiency).

The below chart illustrates a comparison of a moderate allocation strategy vs. a dynamic moderate allocation strategy which makes allocation shifts when efficiency varies by more than 5%.

The backtest covers two full market cycles beginning in August 2000.

Here is the backtest xls … Dynamic AA

Summary

By utilizing mid-term expectations to make shifts to more efficient allocations, the participant can protect assets and achieve greater cumulative asset growth over time.