Index Valuations and (Subtle) Timing

The index funds article suggests a strategy that some people call "mindless" buy and hold; the idea is to choose a sensible portfolio strategy and then stick with it no matter what the market happens to do.

An alternative strategy would be to take valuations of different index styles into account, and then make subtle adjustments accordingly. The key word there is "subtle": if one style looks overvalued you probably still don't want to sell out of it entirely; but you might consider looking for an alternative place to invest your new contributions.


Example: Small Caps in 2005

By mid-2005, small caps had enjoyed a remarkable run; and on July 20 the Associated Press ran an article containing this frightening quote:

"[Active] Small-cap managers have faced an unusual challenge over the last several years: They've had too much money to invest."

Too much money chasing a limited supply of anything can mean price inflation; and a quick check of P/E ratios suggested that small caps had in fact become pricey relative to the rest of the market:


Style Index Representative
P/E *
    Large     Russell 1000         IWB 18.16
TSM Russell 3000       IWV 18.21
Small Russell 2000 IWM 18.75

   * P/E ratios from iShares as of 7/19/2005. See the styles page for a description of these indexes.


The popularity of small caps had even affected Small Value stocks, making them look less value-y than a few other value choices:


Style Index Representative
P/E *
Large Value Russell 1000 Value IWD 14.57
Value Russell 3000 Value IWW 14.63
D.J. High Yield DVY 15.27
Small Value Russell 2000 Value IWN 16.34


What this suggests is that if you normally like Small Value, you may occasionally want to look into alternative value choices, such as large- or TSM-value, or high dividend yield indexes.      
Morningstar Snapshot

Update: December 2005

This page first appeared in July 2005, and the timing wasn't particularly good: small caps continued to do well for the rest of the year. That means that in 2006, large caps are definitely poised to... no, wait - we don't make predictions here, we just explain things. Keep working on that long-term plan, amigo.



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Article Contents
Small Value Intro
Why Small Value?
Which Small Value?
Checking Significance
Checking Valuations
Books & Links

Article Contents
Index Funds Article