Graham and Dodd tactical allocation rules based on market PE

From Kitces and Pfau in AAII.

Though there are a multitude of ways to define an undervalued or overvalued market, we rely on the switching rules developed long ago by Graham and Dodd (“Security Analysis: The Classic 1940 Second Edition,” McGraw-Hill, 1940). They suggested maintaining the neutral asset allocation when valuations fall within a range between two-thirds and four-thirds of their historical average value. Graham and Dodd increase the stock allocation when valuations are less than two-thirds of their average, and decrease the stock allocation when valuations are more than four-thirds of their average. These numerical bounds correspond to evolving CAPE values of approximately 10 and 21 over time. Given the volatility of the CAPE ratio, these bounds also roughly correspond with the bottom and top quintiles of the historical valuation distribution, which are CAPE values of 11.1 and 21.2 (see Figure 1).

These results suggest that the valuation-based approach is generally superior to the rising equity glide path approach and the fixed equity allocation portfolios, as the valuation-based scenarios produce comparable-to-slightly-better results across the board.