To give an example of this I have just read a very good book called Wall Street Revalued by Andrew Smithers. He presents data that shows the following stock market correlations for the period 1999 to 2008:
US to France, 0.92
US to Germany, 0.93
US to Japan, 0.84
US to UK, 0.93
I will assume that stocks always return to their long run PE10 average and so reduce my exposure when stocks are overvalued and increase my exposure when they are undervalued. For my US and International Equities I will use the long run average of the Shiller PE10 to equate to when I hold 21% UK Equities and 15% International Equities respectively. For my retirement investing strategy on a linear scale I will target 30% less asset allocation when the Shiller PE10 average is Shiller PE10 average + 10 and will have 30% more asset allocation when the Shiller PE10 average is PE10 average - 10.
All figures are taken from historic data provided by Professor Shiller. Current stock market data is taken from Standard & Poors and inflation from the Bureau of Labor Statistics. The December market price is the 30 December S&P 500 stock market close.
Chart 1 plots the Shiller PE10. Key points this month are:
Shiller PE10 = 20.6 which is up from 19.8 last month. My UK Equities target asset allocation is now 18.3%. Additionally my International Equities target asset allocation is now 13.1%.
Shiller PE10 Average = 16.4
Shiller PE10 20 Percentile = 11.0
Shiller PE10 80 Percentile = 20.6. This means the S&P 500 is currently sitting right on the 80 Percentile.
Shiller PE10 Correlation with Real (ie after inflation) S&P 500 Price = 0.78
Chart 2 plots further reinforces why I am using this method. While the R^2 is low there appears to be a trend suggesting that the return in the following year is dependent on the Shiller PE10 value.
Chart 3 plots Real (after inflation) Earnings and Real Dividends for the S&P 500. Real Dividends are still falling however they are still above their long term trend. Real Earnings have a roller coaster ride continually, particularly since about 1990. If the Standard and Poors forecast earnings are to be believed however we are now back above the long term earnings trend.