Saturday, December 5, 2015

High Valuations and Low Yields

This is how your average buy-and-hold investor probably feels right now if they are looking to deploy new capital for the long run.

Today, bond yields are puny while stock valuations are rich. In fact, we currently have one of the worst yield and value combinations in history as seen in the charts below dating back to 1880:


Notice on these charts the years 1921 and 1982, when valuations were very low and yields were high. This launched the two largest bull markets in stocks ever, with the S&P 500 gaining over 4-fold in the Roaring Twenties and 15-fold from 1982-2000. And that's not even including dividends.

Now look at the years 1902, 1929, 1965 and 2000 when we had the opposite: high valuations and relatively low-to-medium yields. This led to all four secular bear markets in the past century, with each one lasting over a decade.

We can visualize this better by creating a scatter plot of the above data. We plot stock valuations (S&P 500 Shiller P/E Ratio) on the vertical axis and 10-year Bond Rates on the horizontal axis. The color of the dots will be used to indicate the future 10-year nominal, annualized, total return of a 60/40 portfolio containing the S&P 500 and 10-year treasury bond fund. This plot is shown below: 

Data for this plot from:

The dark red dots indicate the weakest future 10-year returns while the dark green dots indicate the strongest 10-year future returns. Black diamonds are for years after 2006 which we don’t have future 10-year returns for yet. One thing immediately jumps out: Dots in upper left hand of graph correspond to very weak future returns while dots in lower right correspond to strong returns. Everything else is a mix.

Currently, we are sitting in an area that would suggest a high likelihood that stocks will be weak (annual returns under 6%) for the next 10-years. Although admittedly, my chart only gives a very rough idea of future returns, a model with better predictive power has been produced by market analyst John Hussman. According to his chart below, we see that future 10-year returns on the S&P are likely to be near 0%.

Source: Hussman Funds

You might be saying “This is not fair. We just recently came out of a weak decade!”

Unfortunately, it’s what the data tells us. While the 2000’s were difficult, the current decade has been very good to us so far. It would be very healthy for the market to churn sideways, digest gains of recent years and set itself up for a great bull market further down the road.  

That doesn’t make me feel any better!” you might say. OK, I do have some good news for you.

The scatter plot above only gives a rough forecast for average annual 10-year returns. It doesn’t tell us a thing about the path that those returns will take. 

While in the long-run (5-10 years) markets are tied to valuation and mean-revert, they are dictated by momentum in the short-term (6-12 months). This is why valuation is not a good timing tool - it does not tell us when to enter and exit markets the way momentum does. These two points are really the key differences between value and momentum to understand. Please also refer to our post: The Philosophy of Momentum that tries to explain how momentum works in the market.  

So just because we are likely to face a challenging market environment doesn’t mean we can’t profit. If we look back to 2000, we also had high valuations and low yields. What happened next? Essentially, the stock market went nowhere over the next 12 years (as the valuation model correctly predicted), but in the process there were two times when stocks halved and two times when stocks doubled. In this highly choppy environment, the Global Equities Momentum (GEM) model continued churning out nice positive returns. 

The graph below shows how GEM performed against stocks and bonds in the first decade of this millennium. 

Over this decade, GEM gave a total annualized nominal return of 11.4% while a 60/40 portfolio returned just 2.8%. Furthermore, GEM only had one negative year during this whole period, and even that was a mere -7%. Now that is alpha! In terms of our scatter plot, GEM just turned a dark red dot into a nice green dot.

Side note: While GEM produced admirable returns during the 2000’s, they were quite a bit less than its past 40-year average return of 17.8%. This is not surprising given the challenging market environment.

In summary, today’s high stock valuations and low bond yields will likely mean a fixed 60/40 portfolio will not make much money over the next 10 years. However, the ups and downs during this period are likely to allow tactical GEM investors to achieve better risk-adjusted returns.

This is the real beauty of GEM. We don’t need to worry about valuations, yields, or whether the economy will accelerate or slow down. We don’t need to worry about lost decades. We are in a system that will dynamically change depending on the environment. It’s the buy-and-hold crowd that needs to be worried, arguably now as much as 15 years ago.

Happy holidays and see you in the new year!

Results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Additional information regarding the construction of these results is available upon request. Past performance is no assurance of future success. Please see our disclaimer page for more information.