Great Expectations?

“Strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat.” – Sun Tzu

Expectations play a key part in our investment process, but how can we get to realistic and reasonable expectations? If we set them unrealistically high, we will end up with a high risk strategy that could lead to losses, if we set them too low we may easily achieve our objective but miss out on the possibility of much higher returns. Setting your expectations realistically is a key part of your investment strategy.

There are many ways to set your expectations but many lead to an inappropriate strategy. For example, many pension funds have to assume a level of long term returns needed to meet liabilities. If that rate is high, or well above long term government bond yields, then it is very hard to justify owning Treasuries, as it appears to be admitting defeat at the outset. How can you achieve a 9% long term return by investing in long term government bonds which yield less than 5%? Yet it may just be that Treasury bonds are the best investment for the time being as they have been in the last 6 months as well as over the last 5 years.

Clearly, there is a danger in getting too hung up about any one level of pre-defined investment return and to a great extent investments need to be chosen according to their own individual merits. However, judging from most asset allocations I see in pension funds and individual accounts, investors have remained remarkably optimistic about equity returns, and still are, despite their poor recent 5 year returns and still high valuation level.

The error seems to stem from expectations of the returns investors are likely to get from different asset classes. Naturally enough, investors want high returns, and whether justified or not, it does not take very much to be persuaded to bet heavily on equities. Bonds seem so unexciting and bond yields seem much lower than the returns they would like to achieve.

 

This simplistic approach, however, ignores several important factors - the economic environment, risk and the key factor which is valuation. Your return depends crucially on the price you pay for your asset. Why pay a high price? In every other aspect of our lives we are highly influenced by cost. Shouldn’t we be even more price sensitive when it comes to our investments?

What we will show is that not only are bond yields now historically low, but expectations for returns from equities should also be very low. Investors have either not adjusted to a low return environment or are unwilling to accept this. This means that investors are most likely taking much more risk than is necessary or warranted  given current valuations and realistic expectations.

Equity valuation – a different perspective

            One of the best measures of long term valuation is the price/earnings ratio and this is particularly the case when the earnings are smoothed out by using the 30 year moving average of real reported earnings (with thanks to Myles Zyblock of Royal Bank of Canada). On this measure as shown below the US equity market is still very highly valued in a 100 year context.

*Normalized earnings are derived by taking a 30-year moving average of real reported earnings.

 It should be no surprise that buying equities at higher valuations in general lead to poorer performance. The relationship is highlighted in the following chart for the S&P 500, plotting real normalized price-to-earnings against the subsequent 10 year real stock price return annualized. This was done using yearly data going back to 1901. 

While valuations can often be ignored over short periods of time there is a statistically significant negative relationship between the stock market’s value and it’s subsequent return profile over a longer time frame, like 10 years. This relationship is summarized in the table below.

*Based on a model that regresses price-to-normalized real earnings against subsequent 10-year real stock market returns.

This shows in greater detail the relationship between valuations and future long-term real returns based on estimates from our regression. If, for example, the stock market was trading at a normalized P/E of 15, then a best guess for real returns would be 2.5% per annum over the next decade. In actual fact, the S&P 500 is trading at a normalized P/E ratio of around 35. Based on this model, stocks are estimated to decline by 3.6% per annum in real terms. Grossing this result up by adding in some inflation (say 2%) and a dividend yield (say 2%), we arrive at 0.4% total returns per annum for the next decade... uninspiring prospects, to say the least.

Summary

This is just one approach to forming experience based objective expectations for 10 year returns from the stock market. On this basis the stock market is still very highly valued and your expected 10 year return is close to zero in real terms, and that is before costs!

This reinforces our own previous conclusion that a passive allocation to equities or an index fund is most likely to produce a very disappointing long term result probably with a great deal of volatility in the coming years. There will probably be many good and bad years adding up to very little overall return.

With this background there are only a few ways to achieve good long term returns. One way is by trading the volatility, which few can achieve with consistent success. Another way is by very good stock selection and discipline. Alternatively, one can invest more broadly in alternative assets with better value.

There is always some way to make money but investors need to understand that the game has changed, but current equity asset allocations suggest that most investors do not accept this. Yet many of the most successful asset managers of recent decades clearly do. Warren Buffet has an enormous cash balance and finds it very difficult to find anything to buy. Scott Van Den Berg of Century Management has produced an average annual return of 16% since 1974 with an average cash balance of over 20%. Currently, 60% of his assets are in cash and short term Treasuries.

Always remember that the return is crucially dependant on the price you pay for the asset. If there is nothing to buy at a good price then there is no harm in holding cash and being patient for opportunities to arise. Capital preservation is the first objective of asset management and there is very little point in being invested if asset prices are expensive.

 A post bubble period is very typically a period of very low returns. Understanding the limitations of the current investment environment is a key component in setting your investment expectations and ultimately you success. This is not what investors want to hear, and there are many who will promise great returns. But how well will you be served by chasing high returns in overpriced assets? This may be a reasonable short term tactic, if you know how the get in and out of your position, but it is not a strategy.

It is far better in the current environment to play safe and make consistent positive returns that you can compound. Be highly disciplined and patient for good opportunities. This is a much more realistic approach that involves much less stress, and is much more likely to produce successful long term results.

 

 

 

 

 

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