In addition to regularly rebalancing client portfolios, we analyze future price-to-earnings ratios (called “forward P/E ratios”) monthly to overweight sectors where earnings appear cheap and underweight those where earnings appear expensive based on historical valuations.
Sometimes it is difficult to be a contrary investor because it means buying at a time of maximum pessimism and selling at a time of maximum optimism. However, our dynamic tilt based on the future P/E ratios is one more way to systematize being a contrarian, removing some of the emotion and helping achieve a greater rebalancing bonus for doing so.
A dynamic tilt based on forward P/E ratios tends to do the opposite of chasing returns. If a stock has gone up, rebalancing would suggest trimming it back to its target asset allocation. If it has gone up and increased the forward P/E ratio, a dynamic tilt would suggest setting the target asset allocation slightly lower and selling even more of it. And if a stock has gone down, rebalancing would suggest buying more to bring it back to its target asset allocation. If it has gone down and decreased the forward P/E ratio, a dynamic tilt would suggest setting the target asset allocation slightly higher and buying even more of it.
Studies have suggested that when stocks have a low forward P/E ratio, they have a higher expected mean return. And conversely when they have a high forward P/E ratio, they have a lower expected mean return. We use the forward P/E ratio to tilt all our target stock allocations in our managed portfolios.
Valuations based on forward P/E ratios are suggestive not predictive. We believe that this dynamic tilt adds another layer of contrarian rebalancing to help boost returns which is why we adjust the tilt of target sector allocations monthly.
While our managed portfolios need to wait to have one of our traders implement our dynamic tilt in their portfolio, we can update the investment management direction of our employer-sponsored plan unitized trusts and robo-investing clients to our new dynamic tilt numbers and, the next day, have it implemented in the account’s rebalancing algorithm.