Valuation + Trend Rule

Valuation + Trend Rule

Objective — cut the damage from a major decline that starts at extreme valuations, with a written rule set in advance. It replaces a judgement made under greed or fear.

Risk level — 0 — Zero risk. The CEO agrees level 0 is appropriate (2026-09-25, market-timing task round 7; see cape-timing). Formal Risks sign-off is still pending; the charter routes tier assignment through Risks first, so this stays a draft until Risks confirms. Risk justification — proposed level 0 on the zero-risk test. The rule only ever reduces stock exposure, moving the holder to cash, and never adds exposure. Its cost is state-dependent: when a feared decline doesn’t come, the forgone return is real. It is not level 3 on the timing-judgement test because it needs no judgement; it is mechanical, month-end, and pre-committed. Benefit justification — unverified — needs Talbot. Jurisdiction — Canada for the account guidance (use RRSP/TFSA). The evidence is US 1926–2026, the S&P/TSX 1957–2026 and Japan 1950–2026. U.S. applicability of the account guidance is unverified. Name — Valuation + Trend Rule is a working label, not a coined name. It needs the CEO (JOB_DESCRIPTION scope 3).

Prerequisites

• A written allocation (e.g. 100/0 or 60/40) and a written copy of the rule, signed before it is needed.
• Ideally, the switching happens inside registered accounts (RRSP, TFSA), where exits realize no tax.

Mechanism

Once a month, at month-end:

1. Valuation filter: is the Shiller CAPE at or above the 90th percentile of its own history to date?
2. Trend test: is the index’s total-return level below its 10-month simple moving average?
3. If both: cut the stock allocation, either fully to cash (T-bills, a high-interest savings account or a cashable GIC) or, in the halving variant, by half.
4. Otherwise: hold, or go back to, the normal allocation. Re-entry is automatic when the trend recovers.

Benefits

• Smaller worst cases. US 1926–2026: in 2000–02 the rule lost −8% vs −41% for buy-and-hold. The halving variant cut the worst US decline from −84% to −62% (100/0) and from −63% to −40% (60/40).
• Little or no long-run cost. The full rule earned 11.0% vs 10.3% a year; halving earned 10.2% vs 10.3% (100/0) and 8.5% vs 8.5% (60/40).
• Behavioural. A pre-committed exit and re-entry replaces the two common mistakes, buying heavily late in a bull market and selling after a crash.

Risks

• Crashes that begin from ordinary valuations are not insured. The filter wasn’t armed in 2008–09 (−40%), 1973–74 or 1987.
• Trailing a rising market. The rule trailed buy-and-hold in 29% of rolling 10-year periods (worst −3.8% a year). Since publication (2007–2026) it lagged on return.
• Today the filter is almost always armed (97% of months this decade), so in practice the rule currently behaves like a plain trend rule, with that rule’s higher switching.

Failure modes

• Whipsaws: 22 exits in 100 years reversed within three months, several of them missing rallies of more than 5%.
• Very fast crashes (Oct 1987, Mar 2020) happen inside a single month, too fast for a monthly rule.
• Abandonment: the most common real-world failure is giving up the rule after years of trailing.

Costs

• Forgone return in rising markets (see Risks).
• Trading costs (modelled at 0.1% per switch).
• In a taxable account, each exit realizes gains. TSX 1957–2026, $200k Ontario bracket: the plain trend rule fell from 9.8% to 7.3% a year after tax, below buy-and-hold’s 7.9%.

Tax considerations

Use it inside an RRSP or TFSA, where switching is tax-free. Applying the all-or-nothing rule to only the registered half of a portfolio is, before tax, the same as the halving rule, and the taxable half never realizes a gain. Interest on cash (T-bills, HISA, GICs) is fully taxable outside registered accounts.

Who it may suit

• Financially independent investors, and those near or in retirement, for whom the worst case matters more than the last point of return.
• Investors who know they would sell in a crash and want a rule that decides for them.

Who should avoid it

• Long-horizon accumulators who can genuinely sit through −50% or worse. Buy-and-hold remains very hard to beat on expected wealth.
• Anyone unlikely to follow the re-entry signal. A rule followed on the way out and not on the way back in is worse than no rule.
• Taxable-account-only investors, unless they use the halving variant and accept the tax drag.

Implementation outline

1. Choose the base allocation and the response: halve, or go to cash.
2. Choose the accounts: registered first.
3. Put the monthly check on the calendar (month-end total-return level vs its 10-month average; CAPE percentile).
4. Write down the rule and the re-entry condition, and sign it.
5. Review the rule annually, not after a scary month.

Evidence status

documented — backtested in ~/projects/cape-timing (cape-timing): US CRSP 1926–2026 (monthly, no look-ahead, 0.1% per switch), a robustness grid (CAPE threshold 80–95th × moving average 6–12 months: all 16 settings earned 10.1–11.2% a year vs 10.3%), the S&P/TSX 1957–2026 and the Nikkei 225 1950–2026. Reports: Market Timing at High Market Valuations (https://claude.ai/artifact/BfA8jRojdFHtLArKBj3U8w) and Valuation + Trend Rule (https://claude.ai/artifact/4xd4oHHcwSEwCiJ6PqhrKB). Not modelled in sd-math.

Counterarguments

• “It’s market timing.” Yes: rules-based, pre-committed and modest. Asness, Ilmanen and Maloney (2017) conclude that valuation timing alone doesn’t pay, but that adding momentum helps. “Sin a little.”
• “Six rules and 23 settings were tested.” Multiple-testing risk is real. The defence is the plateau across settings and the prior literature (Faber 2007; Asness 2017; Clare et al. 2017), not the best cell.
• “The edge is mostly 1929–32.” Largely true for the full-switch version’s return edge. The halving variant’s case rests on drawdown reduction over 1926–2026, not on extra return; era-by-era results for halving are not yet computed.

Variants

• Halving (the recommended practical form): cut stocks by 50% when the rule fires; 100/0 becomes 50/50, and 60/40 becomes 30/70.
• Trend only (no valuation filter): larger drawdown reduction (the US worst decline fell from −84% to −43%) at about 0.7 points a year of return.
• Rate-adjusted valuation (Excess CAPE Yield ≤ 25th percentile): similar results.
• Leverage side: deleverage when the rule fires, and re-lever when it clears. See pre-decline-deleveraging.

Related strategies

pre-decline-deleveraging · post-decline-deployment · buy-more-low · conservative-leverage-ratio

Sources

• cape-timing — code, data provenance and gates
• Asness, Ilmanen & Maloney (2017), Market Timing: Sin a Little, JOIM
• Faber (2007), A Quantitative Approach to Tactical Asset Allocation (10-month SMA rule), as cited
• Clare, Seaton, Smith & Thomas (2017), Reducing sequence risk using trend following and the CAPE ratio, FAJ
• Zakamulin (2014, 2016) — look-ahead and cost biases in moving-average backtests
• Kitces & Pfau (2015), Retirement Risk, Rising Equity Glide Paths, and Valuation-Based Asset Allocation, JFP

Open questions

• The coined name (CEO).
• Tier confirmation: the CEO agreed level 0 on 2026-09-25; Risks sign-off is pending.
• A Canadian valuation signal: the backtest uses US CAPE for the TSX, because no complete Canadian CAPE series exists.
• Client-facing use needs supervisor pre-approval (MDW-review §6.3). See the MDW offering successor task.