By |Published On: August 3rd, 2015|Categories: Tactical Asset Allocation Research|

Last week we had a fairly long post on a valuation based asset allocation strategy that might actually work. This post followed a couple of other research projects on the issue, which showed limited evidence for simple valuation-based timing strategies.

Now there is a new paper on Warren Buffett’s favorite timing mechanism, Market Cap/ GNP (or GDP). We’ve discussed this metric in 2013, which suggested one get out of the market, and the out-of-sample results were horrific–the market has been on a tear!

Below is a link to the new paper and abstract (h.t. CXO advisory).

Select quotes from the paper:

Our analysis shows that Warren Buffett’s market value of all publicly traded securities as a percentage of GNP (MV/GNP), and its parent the lorgarithm of the market value of all publicly traded securities as a percentage of GNP (lnMV/GNP), can be a statistically significant predictors of future market downturns. However, for these measures to work, we need to use time-varying confidence-based thresholds rather than fixed thresholds.

The authors continue:

This conclusion dispels a common myth about the MV/GNP ratio: that absolute level matters. This myth has led market commentators and investment practitioners to suggest that the level of the MV/GNP is the harbinger of an impeding market meltdown.

The authors examine a bevy of measures:

  • MV/GNP with a fixed threshold at a 120% level;
  • MV/GNP with a threshold computed using a standard 95% one-tail confidence interval based on a Normal distribution;
  • MV/GNP with a threshold computed using Cantelli’s inequality;
  • logMV/GNP with a fixed threshold at a 120% level;
  • logMV/GNP with a threshold computed using a standard 95% one-tail confidence interval based on a Normal distribution;
  • logMV/GNP with a threshold computed using Cantelli’s inequality;

And here are the core results, highlighting that absolute measures stink, but time-varying metrics may be promising:

market cap to gnp predictions

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Conclusion: The results are mixed (absolute doesn’t work while time-varying works) when it comes to tactically allocating assets based on market valuations. This result is in line with much of our own research.

We provide more information on our take on tactical asset allocation and our summary of various concepts.

About the Author: Wesley Gray, PhD

Wesley Gray, PhD
After serving as a Captain in the United States Marine Corps, Dr. Gray earned an MBA and a PhD in finance from the University of Chicago where he studied under Nobel Prize Winner Eugene Fama. Next, Wes took an academic job in his wife’s hometown of Philadelphia and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management firm dedicated to an impact mission of empowering investors through education. He is a contributor to multiple industry publications and regularly speaks to professional investor groups across the country. Wes has published multiple academic papers and four books, including Embedded (Naval Institute Press, 2009), Quantitative Value (Wiley, 2012), DIY Financial Advisor (Wiley, 2015), and Quantitative Momentum (Wiley, 2016). Dr. Gray currently resides in Palmas Del Mar Puerto Rico with his wife and three children. He recently finished the Leadville 100 ultramarathon race and promises to make better life decisions in the future.

Important Disclosures

For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Third party information may become outdated or otherwise superseded without notice.  Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency has approved, determined the accuracy, or confirmed the adequacy of this article.

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).

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