As we cross the halfway mark of 2020, it is important to step back and quantify how stock market values are positioned today compared to history. Are stocks around the globe "cheap" or "expensive?" After all, as Warren Buffett famously said, "Price is what you pay; value is what you get." An answer to the value question can involve measuring the relationship between stock prices and long run profits (a method popularized by Professor Robert Shiller, known as the CAPE ratio). Using CAPE data available from Research Affiliates, what percentage of observed history have various developed (D) and emerging (E) markets offered a more compelling value than what is currently priced? See if anything jumps out at you:
The US (represented by the S&P 500) is currently in the 93rd percentile, meaning it's been more expensive than today only 7% of the time. Now, we can't say with certainty that the S&P 500 is destined for poor future returns--no understanding of the past reveals what will happen in the future. But based on history, the odds are not favorable for the S&P 500 to produce Siegel's constant 6.5% real return over the next decade. By some estimates, investors will likely receive less.
Should investors make changes to their investment strategy based on valuation? What information is helpful and should be incorporated when deciding how to allocate investments? One simplified framework provides three primary methods to construct long-term investment portfolios:
All three of these points can be valid, as long as they are not confused with each other. Let's continue by looking at the valuation question through each of these three inputs.
First, understanding the conventions of long-term investing is key to achieving success. Stocks historically earn an excess return over safe investments, called the Equity Risk Premium (ERP). The ERP exists for one reason; namely, compensation for the volatility of equity returns and long periods of waiting-- not just for the return on capital, but at times for the return of capital. Historically, the ERP has amounted to 6.5%/yr after inflation in the US and 5.2%/yr globally. There is no ongoing action required when acting solely on convention--other than periodic rebalancing-- just make sure your time horizon is long enough to ride out transitory volatility and that your willingness and ability to take risk is consistent with the percentage allocation to stocks. What's left is the hardest part-- waiting.
Prediction deals with understanding the past and developing and applying principles to best estimate how things may be similar or different in the future. Can we assume the ERP relationship? How long is long enough to be assured of a positive real return from stocks? There is historical precedent that paying too high a price limits future returns, sometimes for decades. And in the cases of China in 1949 and Russia in 1917, there have been markets that went to 0. As one data scientist pointed out, "We have one data set of observed history and are living within it"-- in other words, be careful defining your conventions, since we have yet to examine all of the data. Thus, the ERP offers the potential-- never promised-- level of excess return. If 6.5%/5.2% are the historic ERPs, when have markets produced the high and low returns within the average? CAPE methodology aims to help quantify when future returns may deviate meaningfully. When markets are near their historical extremes-- above 85% toward expensive or under 15% toward cheap--adjusting your allocation makes sense if you have confidence these relationships will hold.
But what are markets actually doing? Expensive markets can become more expensive and cheap markets can continue to become cheaper. A framework for valuation alone does not ensure success. Markets do show persistence of returns; simply stated-- positive returns follow positive and negative returns follow negative. This investment factor, known as momentum, shows up within groups of securities (known as time-series momentum) and between asset classes (cross-sectional momentum). Since the last recovery began in 2009, the US stock market has persistently outperformed the rest of the world, and presently, that trend continues.
While each of the three methods have a different take on what investors should own, or how much to own at a given time, consider the utility should all three factors converge. As outlined above, global equities have produced an ERP of 5.2% historically, 80% of what's been provided from US stocks. With current valuations in much of the developing world in the cheapest quintile (compared to the top decile in the US), that leaves one missing piece--rotation from US to non-US stocks. Research from the Leuthold Group found that 5 out of 7 turning points of leadership change between the US and non-US Equity markets since 1970 coincided with a cyclical bear market low. The Covid pandemic has caused a global recession and bear market. We should not expect all economies and markets to recover equally. Investors should be prepared for the possibility that non-US stocks outperform in the coming years. What if such outperformance even started in Asia, the epicenter of Covid? If there is anything we have been reminded of in 2020, it is that unexpected things can happen. Portfolios should be prepared for all outcomes.