Bridge over ocean
1 November 1993 Financial Analysts Journal Volume 49, Issue 6

Tactical Asset Allocation: Pros and Cons

  1. James D. MacBeth
  2. David C. Emanuel
Numerous consultants, investment advisers and analysts have put forth what appears to be very persuasive evidence that, contrary to the random walk hypothesis, traditional measures of value such as price/book ratio, dividend yield and price/earnings ratio can forecast the direction of stock prices. But the evidence grossly overstates the true power of these measures. Common errors in analyzing data and backtesting investment strategies lead analysts to conclude that these measures have more power than they actually do. There is, however, a systematic relationship between stock market returns and these measures of value. In particular, the probability distribution of excess equity returns exhibits positive (negative) skewness when dividend yield or price/book ratio indicates an undervalued (overvalued) market. Given this skewness, one must question the efficacy of mean/variance analysis, which does not look beyond means and standard deviations. While traditional measures of value do convey some information about future returns, this information is not what investors have been led to believe. Investors following tactical asset allocation strategies based on these measures of value should reexamine their strategies in the light of this research.
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