Lance Gunkel and his colleagues at Syverson Strege & Co. were frustrated by the market’s wild swings over the past two years, and so were their clients.

“The clients were understandably upset being told, ‘Just hold on, you’re a long-term investor, buy and hold and everything will come out in the end,’” said Gunkel, the firm’s chief investment officer. “We were frustrated by that, because we felt the market was either being punished too severely or it was being overbought. But we felt that we didn’t have a good metric to support our feelings, and we didn’t want to rely solely on gut instinct.”

Irrational market?

After researching numerous market valuation strategies, the West Des Moines fee-only financial planning firm chose a method known as Cyclically Adjusted Price Earnings (CAPE) on which to base a strategy for gauging how much the stock market is overvalued or undervalued.

Also known as the Shiller P-E Ratio, the method was popularized by Yale University professor Robert Shiller in his book, “Irrational Exuberance.” According to Shiller, the stock market was overvalued for most of the 1990s and did not reach fair value until the early 2000s.

The ratio is calculated by dividing the Standard & Poor’s 500 stock price index by the earnings for the S&P 500 for the past 10-year period to smooth cyclical bumps. That ratio is then divided by the historical average to determine the extent to which the market is overvalued or undervalued.

As of late December, the S&P 500 was at 1,258 and the CAPE stood at 23, compared with the ratio’s historical average of 16.4. When the current CAPE (23) is divided by the historical ratio (16.4), the resulting value of 1.4 indicates a market that is 40 percent overpriced.

Long-term strategy

Syverson Strege adopted its new equity allocation strategy in October, after about a year and a half of preparation and modeling to ensure it fully understood the approach.

For a firm that has traditionally maintained a buy-and-hold strategy, “it’s a sea change, really,” Gunkel said. However, the approach is still a long-term strategy and not a shift to short-term market timing, he said.

“Rather, you’re setting yourself up for long-term positioning based on whether the market appears cheap or expensive,” he said. “We recognize that it may take several years for this theme to play out in the market. So you have to be patient. It’s certainly not a short-term approach.”

The potential benefits depend upon how willing a client is to modify his or her stock allocations based on the ratio, Gunkel said. In most instances, the firm will recommend moving no more than 10 percentage points up or down in stock allocations, or a within a range of 20 percentage points.

“Over a long-term period, we’re maybe talking a half percent annualized (in earnings gains), but we’re obtaining some risk reduction as well,” he noted.

Another West Des Moines investment firm has used the method for about four years as part of its market valuation model.

“It’s just one of many inputs we use,” said Sayer Martin, portfolio manager with Clarity Asset Management Inc. The firm also uses ratios that take into consideration factors such as replacement cost of assets, the cost of capital and earnings growth rates in valuing the overall market, he said.

“All the inputs considered, the market doesn’t look that expensive to us,” Martin said, noting the current CAPE ratio of 23. “If we saw CAPE be in the 25 to 30 range, then we would start to get worried, but given where it is today, it’s not necessarily at a valuation extreme.”

On average during the past 100 years, buying stocks while the CAPE is at 23 has produced a zero percent return in the following three years, Martin noted.

“Overall, there is some argument to reduce some exposure to stocks, but for someone with long-term goals, it doesn’t make sense to change it that much,” he said. “If you’re going to need the cash in the next three years, it should not be in stocks.”

‘Not sitting on our hands’

Syverson Strege’s investment committee evaluates the CAPE monthly, but doesn’t make allocation shifts more frequently than quarterly, Gunkel said. Based on the research it did, the firm expects to average just one allocation shift every two years.

“The interesting thing for me,” Gunkel said, “is that even though we’ve opted to make only small allocations, our clients seem to feel good that we’re not just sitting on our hands,” he said. “And by using CAPE, it allows us to make decisions without emotion being a part of it.”

Syverson Strege also uses the ratio to help clients identify when to invest additional dollars upon retirement or the sale of their business.

“We are able to utilize the CAPE ratio as a guide as to whether the client should invest the cash currently, wait, or dollar cost average over a period of time,” Gunkel said.

For 2011, “I think we’ll see a drop in the overall market, which means we have our clients tilted slightly out of stocks,” Gunkel said. “Whether that bears fruit in 2011, I’m unsure. But we’ve taken some risk off the table as we enter the new year.”