Abstract
Asset allocation plays a central role in determining investment outcomes, and available evidence shows that portfolio results can be enhanced through tactical asset allocation if managers use the simple price-earnings ratio as a predictor of equity returns. Recently, some international evidence has emerged which shows that, by augmenting the price-earnings metric with information about consumer price inflation, further enhancements can be achieved in tactical asset allocation. This study reviews these arguments as they apply to South Africa, and finds that an inflation-augmented price-earnings ratio is more successful in forecasting equity returns than is the simple price-earnings ratio. Moreover, the metric is found to be significant in explaining relative asset class returns. On a risk-adjusted basis, however, the tool fails to improve the portfolio results when compared to a buy-and-hold strategy.
Highlights
Asset allocation plays a central role in determining the results of active portfolio management, with tactical asset allocation offering potentially substantial improvements in investment results for skilled market timers
While the results presented above show that the price-earnings ratio and IAPE metric have some power in forecasting equity returns, the analysis ignores opportunity costs
This paper tests the power of two instruments that have been shown to have predictive power in other markets, namely the price-earnings ratio and the IAPE metric
Summary
Asset allocation plays a central role in determining the results of active portfolio management, with tactical asset allocation offering potentially substantial improvements in investment results for skilled market timers. The substantial theoretical attraction of tactical asset management remains, so the search for tools that aid asset allocation is ongoing On this front, there is some evidence to suggest that the price-earnings ratio is a powerful predictor of equity returns. Shows that the IAPE measure produces a better forecasting performance than the simple priceearnings ratio in predicting returns from equities Using the results of an experiment performed on a sub-sample of the data, Section 8 shows that the IAPE metric could have been used to guide tactical asset allocation in improving portfolio returns over the sample period.
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