Avoiding the Unintended Migration from Investor to Speculator
The identification of value/price in the allocation of capital is essential to successful investing. Assets purchased at levels above intrinsic value reflect an approach based on hope and momentum not sound risk/reward analysis and normally portend negative results. The investor in this situation begins the unintended migration from investor to speculator. It’s ironic that all investors are experienced in making ongoing risk/reward decisions as part of daily life. However, in the investment world the danger is not necessarily as apparent and the euphoria generated by rising markets and all-time highs can hide inherent risks. Rational expectations, broad experience and solid risk/reward analysis are required to understand and mitigate these financial market risks. The linkage between future returns and entry valuations is well documented. There is overwhelming evidence that long-term returns will be lower when initial purchase levels are inflated - The converse is also true suggesting low initial valuations result in higher long-term returns. This reality is important to all investors but particularly important to those investors with a shortened investment time horizon and those approaching retirement.
Are Equities overvalued? I answer the question by first suggesting the prudent investor should begin to analyze the structure of their portfolio and look at moving his/her equity component into a more defensive position. (I will provide options/solutions later in this piece.) The equity market has gone almost straight up over the last few years and recently has brushed aside any pretense of value selecting (stock picking.) Frankly, this is why hedge funds and fund of funds have struggled in this environment. It is also why index funds will become vulnerable. Sometimes a portfolio is built for speed and at other times it is built for survival - Portfolio construction should be seen as a dynamic process particularly in periods of enhanced uncertainty. In the current environment, I would strongly advocate tactical strategies over traditional buy and-and-hold strategies. I would also employ a strategy familiar to those that followed my comments in the 2007-2011 period i.e. “You win by not losing.” I offer these views knowing fully well that overvalued markets can be extended to become more over valued. Having said that, it is crucial to understand as emphasized in the first paragraph the undeniable linkage between purchasing securities at inflated prices and below average future returns. It goes without saying that simply holding overvalued securities has its own set of risks.
Let’s dig a little deeper - Ned Davis Research, a quantitative research organization provided the box score shown below which suggests that current valuation measures are
richer than the majority of peaks associated with all 35 prior bull markets recorded since 1900.
Five of the six valuation ratios show the market is more overvalued today than it was at between 82% and 89% of those peaks. They are:
- The cyclically adjusted price/earnings ratio championed by Robert Sheller, calculated by dividing the S&P 500 by its average inflation-adjusted earnings per share over the past decade.
- The dividend yield, which is the percentage of a company's stock price represented by its total annual dividends.
- The price/sales ratio, calculated by dividing a company's stock price by its per-share sales.
- The price/book ratio, calculated by dividing a company's stock price by its per-share book value, an accounting measure of net worth.
- The Q ratio, calculated by dividing a company's market capitalization by the replacement cost of its assets.
It is noteworthy that there is such agreement among these ratios even though each calculates the market's valuation in a profoundly different way.
The sixth data point—the traditional price/earnings ratio, which focuses on trailing or projected 12-month earnings—is the one that paints the least-bearish picture. Still, it shows the market to be more overvalued than it was at 69% of those past market peaks. *
The July BofA Merrill Lynch Fund Manager Survey provides us with some additional anecdotal evidence. It suggests that 61% of global asset allocators are currently overweight equities. This represents the highest level since 2011. I always get nervous when fund managers maintain or extend their over-weightings in equities in periods when valuations are above fair market value. Interesting, 21% of the respondents in the survey believe that equities are overvalued. That is also the highest level since 2000. It is important to recognize that not all analyst concur with the overvalued argument however, those suggesting equities are fairly valued represent a clear minority. My goal in this piece is to establish or reinforce the idea that the flipside of overvalued equities is negative future returns. As investors, we cannot have it both ways. Please remember that forward return forecasting is a reflection of the valuations at the time of the analysis
How did we get here?
It all started with the Fed’s stated goal of increasing the wealth effect by setting conditions supportive of taking risk assets above intrinsic value i.e., solving a bubble problem by setting the conditions for a new bubble. John Hussman states it a little differently. “It is certainly true that from a psychological standpoint, the Fed has induced the same sort of yield-seeking speculation that drove investors into mortgage securities (in hopes of a “pickup” over depressed Treasury-bill yields), fueled the housing bubble, and resulted in the deepest economic and financial collapse since the great depression. This yield-seeking has clearly been a factor in encouraging investors to forget everything they ever learned from finance, history, or even two successive 50% market plunges in little more than a decade.” I believe the Fed has succeeded in taking risk asset above intrinsic value and failed broadly in creating real wealth that translate into sustainable economic growth. The unwinding of the Fed’s $4.3 trillion balance sheet will not be easy and will need to be done deftly in order not to increase economic and market volatility.
What should investors do?
I believe investors need to understand that we are on the cusp of exiting an artificial investment environment. The Fed has orchestrated current equity and bond valuations. While I possess no crystal ball I expect that the coming investment environment (5-10 years) will be seen in hindsight as more challenging than this most recent difficult period. I believe the ‘free ride of the last couple of years is ending. Geopolitical and geo-economic issues are getting more complex and domestically the United States will have to deal with a broad set of internal conflicts none of which in my opinion is greater than the debt crisis.
Investors need to arm themselves with an understanding of the broad options available and then custom fit specific products/options to meet their individual investment objectives. Choosing a given option is dependent on each investor’s conviction or assessment of coming market events. Importantly, investors have the ability to measure how much of a given option is utilized.
- Exit the equity market
- Increase cash component
- Exit index funds
- Initiate or increase weightings to defensive low volatility long/short fund of funds
- Initiate or increase weightings to defensive low volatility long/short funds
- Initiate or increase weightings to traditional stock picking
- Initiate or increase weightings to both equity and bond alternatives
- Initiate or increase weightings to international equities
- Initiate or increase weighting to selected domestic and international bonds
- Make every effort to structure a uncorrelated diversified portfolio
I will end this brief piece by suggesting selected fixed income products will outperform equities in 2014 despite much of the consensus forecasts.
© Andres Capital Management
