I had an idea today that I might do some back testing with. It’s kind of a slant on MPT with a dynamic cash allocation. What if instead of having a fixed cash allocation of say 30% which you re-balance to each year, you instead use the p/e ratio of whatever indices you’re invested in (S&P, FTSE100 etc) to determine that allocation?
Assuming a p/e of 14x is fair value, 7x is very cheap, 21x is very expensive and 28x is an insane bubble, what if you used double that number as the cash %? So each year, if say the FTSE100 had a p/e of 14x you’d set your cash allocation at 28%. If the p/e was 7x you’d have the cash allocation at 14% and if the p/e was 28x you’d have the cash allocation at 56%.
This seems reasonable at first glance since at 14x, 28% cash is a reasonable safe amount. At 7x the stock market is historically cheap (with a better than average probability of going up) and yields are high so you load up on it with only 14% cash. At 28x the stock market is historically very expensive (with a better than average probability of going down) with low yields so you don’t want much exposure, i.e. 56% cash.
I think I’ll do some back testing if possible and see what history says.