The Independent Market Observer

1/22/14 – Safety Lines on the High Wire

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jan 22, 2014 9:19:34 AM

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If you look at the future returns, by valuation level, in the chart in yesterday’s post, you see that the higher the initial price, the lower the future returns. This makes sense both theoretically and empirically, but it creates a problem for investors right now, in that their expectations are totally out of line with what has happened in the past. While investors often expect miracles, many investors today are essentially relying on one—and have no idea that is the case.

The problem isn’t limited to stocks, either. For bonds, assuming interest rates remain the same, returns are the coupon payments—and then you get your money back. Your real return is coupon less inflation, which means on a par, on a real basis, with what stocks are likely to return on average. If rates rise, on the other hand, you could face capital losses, which would further erode returns. The only scenario in which bonds might make up for lower stock returns is if interest rates decline—and that’s very unlikely to happen on a consistent basis over the next decade. Anyone looking for higher returns won’t do it in bonds.

As an individual investor, and an advisor to other investors, this is the key problem I see for the next decade. The question is, how can we solve it, or is it solvable at all?

As a first step, let’s define the issue a bit more clearly. For both bonds and equities, the problem is that they are very richly priced, on a P/E or interest rate basis, respectively. At some point, prices will adjust to normal levels, which is the essence of the problem. This leads to two questions: (1) how will that adjustment happen, and (2) given the how, is there a way to minimize the effects of the adjustment on your investments?

There are two ways prices can adjust to normalized levels. For stocks, since prices are valued in relation to earnings, the slower way is to remain roughly constant while earnings grow. Higher earnings, with constant prices, will eventually lower the P/E ratio to more normal levels. The quicker way is for prices to drop back in a correction. Either way can result in a return to normal valuation levels.

What we’ve seen in the past is that prices do eventually adjust, rather than staying stable until earnings catch up, and may do so very quickly and very substantially. This is the risk we really must guard against. Stable prices, although not giving us any gains, also don’t cause any losses, and so are easier to take. Sudden adjustments, which could create large losses, are much more damaging. They aren’t called crashes for nothing.

The traditional method that can help minimize the effects of price adjustments —and it’s a good one—is asset allocation and regular rebalancing. If you think about it, using truly noncorrelated assets should mean that some go up while some go down. If you regularly rebalance, you are, in effect, selling high and buying low. Theory and practice line up here beautifully, and it works. It does, however, require substantial discipline—and real noncorrelation.

What we saw in the great financial crisis was that many assets that we thought behaved differently didn’t. We didn’t have the real diversification we thought we did. We also saw that many people didn’t rebalance but continued to load up on investments that had performed well recently, neglecting those that had done less well recently—the exact opposite of what they should have done.

The “failure” of asset allocation in 2008, then, was not the failure of the model but that of execution. Asset allocation and regular rebalancing remains a core principle—a core safety line, if you will—of investing, especially in highly priced markets. Regularly taking gains off the table helps raise the probability that you’ll end up keeping some of them. As we have seen, though, in a real correction, this may still result in substantial losses—more than anyone was really expecting.

Another way to manage risk is to try and get out of the markets when they look richly priced. “Market timing” has a bad reputation, but there’s no denying that the best way to avoid a disaster is to be somewhere else.

Post-2008, “tactical asset allocation” has made significant gains in mind share. TAA is, at its heart, the notion that managers should buy assets that are likely to do well and avoid those that are likely to do poorly. This is, of course, completely different from market timing. (Really. Pay no attention to the man behind the curtain.) Since 2008, though, TAA has become less popular as it has generally underperformed traditional allocations, which have been driven higher by the recovering stock market.

Another way to look at this is that market timing, or TAA, was least popular when it was most appropriate—and most popular when it was set to underperform. Why is this? Is this tool useful at all, and, if so, when?

This idea was at the core of a study I did a couple of years ago for Commonwealth advisors, which I will summarize tomorrow.

Asset allocation programs do not assure a profit or protect against loss in declining markets. No program can guarantee that any objective or goal will be achieved.

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