It’s well-established in the literature that valuation metrics—such as the dividend yield (D/P) and the earnings yield (E/P), as well as its cousin, the Shiller CAPE 10—provide important information in terms of future expected returns. In fact, these metrics are the best that investors have for predicting long-term equity results. For instance, the Shiller CAPE 10, a cyclically adjusted price-to-earnings ratio, has been found to explain about 40 percent of returns for the next 10 years.
The negative relationship between current valuations and future returns can tempt many investors into pursuing what are often referred to as tactical asset allocation (TAA) strategies. Such investors increase their equity allocation when valuations are low relative to their historical mean, and lower it when valuations are relatively high.
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