First of all, from a trading perspective, nothing has changed. We are still in a bull market, and as such the correct position is to be invested to the limit of your risk tolerance. Stock valuations are high but not yet frighteningly so. Moreover, the narrative for the stock rally, namely that the Federal Reserve is actively stimulating risk-taking behavior through its interest rate and bond repurchasing programs, is still intact. At the margin, every day, people are throwing in the towel on bonds and some of that money is finding its way into the stock market. Because valuations are high, it is job one for us to be alert to when all of this changes (because the amount one might lose grows as the market rises). The earliest warning signal, deteriorating market breadth, is already flashing. However, this typically begins several months to over a year before the ultimate top.
From an investing standpoint, however, we might look at things differently. Perhaps the cornerstone of the financial planner universe over the past 30 years is the 60/40 portfolio. With stocks averaging about 10% and bonds averaging 5.5% return over the very long term, a 60/40 portfolio returns 8.2% (6.0% + 2.2%). The best part is that this return comes with a standard deviation that has been consistently less than 10. What more do you need to know? You can safely attach a 5% withdrawal rate to that portfolio because you don’t expect enough volatility to break the plan if the early years are weak. Bonds usually do well in years where stocks don’t, so while the portfolio will lose money from time to time it will never lose all that much and never for all that long.
But, wait a sec…… what if the past 30 years are an anomaly? What if our assumptions, based on the past 30 years, don’t hold true for the next 30? What if:
- Stocks average less than 10% annually over the next 20-30 years (the investment lifetime of a typical investor).
- Bonds average less than 5.5% annually over that same time frame.
- Bonds and stocks have a fairly positive correlation to one another, such that long term bonds do not provide a meaningful hedge to stocks.
If you think about it, point three has already occurred. Most advisers have reduced bond duration and moved down the credit quality spectrum over the past four years. We anticipated a surge in interest rates that didn’t occur, but we won anyway because credit spreads narrowed dramatically giving us nice capital gains on our corporate bonds. Going forward, however, we can’t expect our bond portfolios to provide much of a hedge at all to our stock portfolios. Our bond portfolios are now more credit sensitive, so they may well lose money just like stocks in an adverse economic environment or a liquidity squeeze.
Bonds will not average anywhere near 5.5% over the next few decades. We are starting with a 2.85% 10-year yield (the corporate bond ETF, LQD, yields 3.84%), so long bond yields would pretty much have to go below 0% to provide a 5% annualized return over the next 20 years. High yield bond yields are the lowest in history. Furthermore, there are no capital gains to be had in an asset class that now trades at par (or better).
Stocks are a much more interesting and debatable point. What can we conclude about the knowledge that according to Leuthold we are in the top 11% of historical valuation periods? It doesn’t mean we won’t go up next year and the year after that (remember that Greenspan’s “irrational exuberance” speech took place in December 1996, more than three years before the stock market peaked), but as a long term investor one should know that one’s returns are largely driven by valuations at the start of the investing period, as this chart clearly shows.
Source: The Truth Does Not Change According to Our Ability to Stomach It, December 9, 2013, www.hussman.net
When I look at the market commentary I wrote back in January 2009, I was trying to make the point that while current conditions looked grim and nobody knew exactly when they were going to turn around, stock valuations had fallen to a point where on a ten year basis it was hard to imagine that stock investors wouldn’t do quite well. Right now we are probably very near the opposite point in the market cycle from January 2009. It is hard to imagine we will look back at December 2013 as a particularly good time to invest. Some of my reasons other than valuation[i] (which is a notably poor timing tool):
- Sentiment (the AAII investor sentiment survey recently had 58% bulls and 15% bears, a spread only seen near market tops)
- Widespread fund closings, especially in the small cap area (essentially, more and more top managers are saying that they can’t find attractive places to put new money). Moreover, some of the top hedge funds are closing or even in some cases returning capital for lack of opportunities.
- Lack of leveraged buyouts. Think about it, with borrowing rates low and investors optimistic, we should have seen a lot more LBO activity over the last 18 months. Smart money knows it can’t make much of a return if they have to pay a 15-25% premium to current valuations
So where does that leave us? I am not arguing that we should tell investors that they should not expect 8.2% annual returns year after year (you already know this and have probably already told them). I am arguing that it is the standard deviation part of the bargain you need to address. In other words, not only is 5.7% a more realistic annual expectation for a 60/40 portfolio (0.60 times 7.5% for stocks, 0.40 times 3.0% for bonds), but it will probably come with a higher standard deviation than a 60/40 portfolio has traditionally provided (because stocks are overvalued and corporate bonds will not provide the low correlation balance government bonds used to).
The institutional world reached this conclusion years ago, which is why they have been promoting “risk parity” strategies that have higher bond and lower stock weightings. They acknowledge that it will take more bonds at these lower yields and less stocks to reach the same standard deviation targets. I believe this lesson applies to individual investors as well. They generally do not demand a 60/40 portfolio; they ask for the best return you can give them within a certain volatility range. That is where our challenge is going to be. Given current valuations, a portfolio that gives you a standard deviation of 9 might be something like 52% stocks, 23% bonds, and 25% alternatives & cash. It may be time to think in terms of creating 6, 9, 12, and 15 expected standard deviation portfolios instead of 40/60, 50/50, 60/40, or 80/20 stock/bond portfolios in order not to give our clients unpleasant surprises over the next two decades or so.
[i] Okay – one comment on valuation from Jim Chanos: “A few years back, I felt the U.S. was the best house in a bad neighborhood for a cliché hackneyed term and certainly there were better places that I think on a macro basis to be short like China. Our thinking is changed on that now. I think that the U.S. market is pretty fully discounting an awful lot of good news. While one can never be precise on markets and that’s not why my clients pay me, we’re finding many more opportunities (on the short side) in the U.S markets than we found a few years ago.
The U.S. market at roughly 1,800 on the S&P is trading at 19 times earnings. I am always sort of befuddled because people use a much lower figure on that…we went back and triple-checked trailing 12-month S&P 500 earnings and they are only $95. A lot of companies report earnings before the bad stuff and we’re talking about GAAP earnings — actually talking about real accounting earnings — they are only $95. So for you to believe that the market is only at 14 times, 15 times next year’s number, you have to make some pretty robust assumptions on earnings growth to get that $95 to the $120 or $125 figure.”
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