Thursday, April 16, 2015

P/E Multiples vs (Past and Future) Returns and Volatility

As I outlined in my previous post The Relationship Between Stocks and Bonds, the S&P 500 yields 3.7% at the current 27 CAPE (cyclically adjusted P/E), attractive from a relative basis to the sub 2% yield of the ten-year treasury. That said, a 3.7% yield is quite low by historical standards. Below is a framework for thinking about why returns should be expected to be lower AND more volatile than their long-term average given these low yields.  

Thinking about stocks in terms of CAPE duration

While bonds, without embedded options, have a pretty well-known duration, there is much less certainty regarding the duration of stocks. That said, a framework for thinking about stocks in terms of their sensitivity to changes in their yield is informative. Stock valuations are highly sensitive to their required yield, with materially higher "stock duration" in the form of P/E multiple expansion at a lower earnings yield than at a high earnings yield. 
  • Low yield = higher "stock duration": For example... at a CAPE of 40, the "required yield" is 2.5% (1 / 2.5% = 40). This means (ignoring convexity), valuations change 40% for each 1% change in the required yield.
  • Higher yield = lower "stock duration": On the other hand at a CAPE of 10, the "required yield" is 10% (1 / 10% = 10). This means (ignoring convexity), valuations change just 10% for each 1% change in the required yield.
Like bonds, the higher the duration (in the form of CAPE), means greater price sensitivity to a move in yield, which should be expected to result in higher forward volatility as well.

Historical returns drive the required yield and CAPE duration

The chart below looks at historical 5-year annualized performance of the stock market going back 50 years, bucketed into 10 distinct groups of ending CAPE values (<4% means the ending CAPE yield was less than 4%, which aligns itself to any ending periods with a CAPE above 25). 

As the chart highlights, low stock yields (and high CAPE) have historically been the result of strong stock performance, as investors are lulled into forecasting low volatility and high returns given their recent experience, despite the poor valuations a low yield means.

The historical result of a low CAPE yield / high CAPE duration

Given the framework outlined at the beginning of this post, one would expect:
  • Low yields = low returns
  • High CAPE duration = high volatility

So... it should come as no surprise that forward returns based on a starting CAPE yield were in fact lower and risk was higher. In fact, when CAPE yields have been less than 4%, the forward average return has been only slightly above 0% or the next five years with materially higher volatility. At the current 3.7% earnings yield, investors in the S&P 500 should not only anticipate lower than normal returns, but higher volatility. Another reason to be diversified to higher "yielding" stocks abroad.

Source: Shiller, S&P

Monday, April 13, 2015

The Relationship Between Stocks and Bonds

A Wealth of Common Sense has a recent post 'Stock Market Losses with Low Interest Rates' that outlines:

  • Just because interest rates are low doesn’t mean stocks can’t or won’t fall. Interest rates are a very important factor in the markets but they’re not everything. 
  • Stocks are risky. To make money you have to be willing to accept occasional losses. Get used to it if you’re invested in risky assets. 
  • Even in a volatile market environment laced with bear markets, stocks can still make money for patient investors.
His points are extremely important and investors should be prepared for this volatility, but there is a relationship between stocks and bonds that I've found helpful when making allocation decisions.

Backdrop: The relationship between stock and bond yields hasn't always been strong

Before the 1960's, there was hardly any relationship between stock and bond yields. The late great Peter Bernstein wrote about a period in the 1950's when dividend yields moved lower than treasury rates for the first time, a phenomenon most investors thought was temporary:
When this inversion occurred, my two older partners assured me it was an anomaly. The markets would soon be set to rights, with dividends once again yielding more than bonds. That was the relationship ordained by Heaven, after all, because stocks were riskier than bonds and should have the higher yield. Well, as I always tell this story, I am still waiting for the anomaly to be corrected.
That differential has finally "corrected" on and off since the crisis, but an investor waiting for it would have missed the 10% annualized stock returns since it first flipped in 1957.

Starting at roughly that same time, the relationship between stock and bond yields grew tight, but instead of a connection through dividends (and the corresponding yield), the connection was through earnings. From the early 1960's through the late 1990's, the Fed Model was viewed as the "new normal". Per Wikipedia:
The model is often used as a simple tool to measure attractiveness of equity, and to help allocating funds between equity and bonds. When for example the equity earnings yield is above the government bond yield, investors should shift funds from bonds into equity. 
The 0.83 correlation from 1965 - 1999 between the CAPE yield (earnings yield based on the cyclical adjusted price to earnings ratio) and 10-year treasury rate provided support for this theory. Since 2000, the correlation between the CAPE yield and 10-year treasury rate has become unhinged at -0.64, highlighting a world where stocks have broadly underperformed in periods of declining rates i.e. flight to quality.

The connection between stocks and bonds... valuations have always mattered

Yet... despite the three stock/bond yield regimes outlined above and in the chart below (low correlation, high correlation, negative correlation), valuations have always driven performance. When the relationship was non-existent, with CAPE yields high relative to bond rates, stocks materially outperformed. When the late 1990's stock bubble pushed CAPE to record highs (and CAPE yields to record lows relative to bond yields), stocks underperformed.

Where do we currently stand? 

Ignoring my view on whether the CAPE is artificially high at 27, we have a CAPE yield of 3.7% relative to a sub 2% treasury rate. Based on history, stocks "should" outperform bonds over the next 10 years (over the past 50 years, they've never underperformed bonds over 10 years when yielding more) and have provided a return in the 2-5% range above the yield on bonds (call it 4-7% nominal at today's levels).

So while stocks absolutely can (and will) sell-off despite low rates at some point, low rates do appear supportive of an allocation to stocks "relative" to bonds here in the U.S. and especially abroad.

Source: Shiller

Thursday, April 9, 2015

A Guide to Creating Your Own Smart Beta Fund

FT tries to define smart beta:

Smart beta is a rather elusive term in modern finance. It lacks a strict definition and is also sometimes known as advanced beta, alternative beta or strategy indices. It can be understood as an umbrella term for rules based investment strategies that do not use the conventional market capitalisation weights that have been criticised for delivering sub-optimal returns by overweighting overvalued stocks and, conversely, underweighting undervalued ones.
A pretty good definition, which is just broad enough to allow for anything and say it's a cure for almost anything. As a result, there has been a proliferation of smart beta ETFs and mutual funds that have, in many instances, gathered an absurd amount of assets from investors, often times with only backtested performance.

While no concept will work over every time frame, the more concerning aspect to me is that interesting concepts that backtested well in one category are being applied to other areas of the market irrespective of supporting analysis and/or whether there is proper liquidity. One highly regarded "fundamental" index provider now has a fundamental index not only within all major equity categories, but also across multiple areas of fixed income, including US high yield corporate bonds. While the 1.07% annualized underperformance of the "smart" index vs the Barclays US High Yield Index over the last 3 years is in itself an issue, the real concern is the incremental 1.10% of annualized underperformance the ETF has to its custom index due to fees + trading in an illiquid part of the credit market. This almost 2.2% annualized underperformance hasn't stopped this almost $700 million fund from taking in another $86mm in assets the first three months of the year!

So... lots of flows, based in large part on back-tested results, with actual results of only limited value. Let’s create our own…

Step 1: Find a Marketable Idea

Leveraging the work from my previous post Is there a Relationship Between the Economy and Stock Market?, let's create a systematic asset allocation index* and call it GDP Growth "Smart Beta". To sell a product, you need a concept that is unique, yet resonates with the masses:

I don't know of any ETFs that are systematically tied to short-term GDP growth as the main factor driving the stock / bond allocation decision

Despite the fact that economists (even good economists) have no idea what's going on, everyone thinks they are an economist (including me... case in point - I started a blog called EconomPic Data)

Step 2: Create a Pitch
Using an exclusive signal, the strategy shifts capital to assets capturing the equity risk premium when deemed attractive and de-risks when valuations are deemed poor, while a proprietary macro overlay identifies periods of relative economic weakness. The resulting portfolio provides equity-like returns during strong market environments, with bond-like characteristics during periods of heightened market uncertainty.

Step 3: Show Backtested Results

Show performance in the best format possible. If total returns are similar, but a time series highlights long periods of underperformance vs the traditional asset class... then only show the time series of the "smart beta" index (and show a total returns comparison vs. the traditional beta separately in a table).

Step 4: Add Leverage

Show how much better returns would have been at similar levels of risk as the stock market, while ignoring the fact that there is no way to know in advance how much leverage you would need to have matched that standard deviation.

Step 5: Profit

Actually, I missed a step. I need a good ETF ticker. Perhaps Goodrich Petroleum would be willing to sell theirs?


Despite what I outline above, I think there is a huge opportunity for systematic / rules based ETFs. That said, I have a hard time understanding why many of these products, sponsors, and providers get a free pass (or in many cases are put on a pedestal) from the same guys that are railing against active management. Also... just because something has worked well in the past and there is academic support that explains (or tries to explain) why it has worked, it doesn't mean it will work in all markets or across all asset classes.

*Each quarter, if the latest one year nominal GDP > the yield to worst on the Barclays US Aggregate Bond Index... allocate the next quarter to stocks (S&P 500); otherwise to bonds (Barclays Aggregate Index). 

Monday, April 6, 2015

Is there a Relationship Between the Economy and Stock Market?

Long story short... yes, there appears to be a relationship between economic growth and stock market performance within the U.S. (and developed world), but that relationship holds only over longer periods of time and does not hold for all countries (less developed countries often "divert" growth to the political elite).

Also, for those interested in the relationship between long-term economic growth and returns across countries, Dimson, Marsh, and Staunton provide a ton of interesting analysis going back 100+ years within the Credit Suisse Investment Returns Yearbook (Figure 13 on page 28). The high level takeaway: "Though difficult for investors to capture in portfolio returns, strong GDP growth is generally good for investors."

Below are two pieces of analysis that outline what I feel drive the relationship between underlying economic growth and the U.S. stock market;

  1. The economy's impact on valuation (economic growth provides a base for corporate earnings, which drives valuations, which drives returns)
  2. Economic contractions that severely impact stock market performance

U.S. Economy vs. U.S. Stock Market - The Valuation Story

The best part about taking an almost 3 year hiatus from blogging is that I can recycle about 90% of my previous ideas and they will seem new. Here is one I initially ran in May 2010, then revised to the format below in February 2012. The background of this is that over the long run, equity valuations and earnings have both grown at roughly the same pace as nominal GDP. This makes intuitive sense... while earnings can absolutely grow slower than the economy (especially in emerging markets with less developed investor protection), if they consistently grew faster than the economy, then earnings would eventually become larger than the entire economy (not possible).

With that in mind, the below chart shows:
  • Blue: the S&P index
  • Red: the ending 2014 value is set to the 2014 year-end value of the S&P 500 index, then brought back in time by the nominal GDP growth rate (GDP data is available at the Bureau of Economic Analysis) - 1929 is the first year the BEA produces annual GDP growth rate

This is an attempt to compare the S&P's historical valuation relative to the size of the US economy, relative to the current level of that relationship. When the S&P 500 (blue) is below the nominal GDP line (red), then the S&P 500 was cheaper on this relative measure than it is now (when the lines cross valuation levels were equal to those in place today).

The chart below shows the relative valuation for each year from 1929 through 2004 (relative to its current value of 0; again if less than 0, the S&P was cheaper by this measure), along with the subsequent 10 year forward change in the S&P 500 total return (annualized). This chart outlines that historically there has been a significant relationship between the underlying economy and stock market. When the S&P composite has grown at a slower rate than the U.S. economy, making it cheap, this has led to historical outperformance.

Of note... there have been many more periods when the stock market was less expensive than the current level, yet the trend-line goes through 0% (the current valuation) on the x-axis at roughly 7.5% annualized (noisy data, but it makes current valuations less stretched than some would think).

U.S. Economy vs. Stock Market - Avoid Economic Contractions if Possible

While the above analysis outlines that the relationship between the economy and stock market generally holds over longer time frames, there has been a relationship worth mentioning over shorter time frames. Going back to the first quarter of 1947 (as far back as the BEA releases quarterly real GDP) and separating quarterly S&P 500 performance when real GDP was either positive or negative, we see a pretty material difference in performance. Not only were returns much better when GDP was expanding vs. contracting (real returns have actually been negative during economic contractions), but returns were much more volatile when the economy was contracting.

While there is no real way for an investor to know in advance a contraction is coming (though a lot of investors think they can), the key is that if the underlying economy has strength, history points to stock markets as being supported.

Tuesday, March 31, 2015

The Disappearing Value Premium?

Eugene Fama and Kenneth French released their seminal white paper 'The Cross-Section of Expected Stock Returns' in June 1992 which added value (as well as size) as explanatory factors that drove market (out)performance. 

Fama and French attempted to better measure market returns and, through research, found that value stocks outperform growth stocks.
Why does the value premium exist? There are broadly two explanations... an efficient market explanation and inefficient market explanation. Back to Investopedia:
On the efficiency side of the debate, the outperformance is generally explained by the excess risk that value and small cap stocks face as a result of their higher cost of capital and greater business risk. On the inefficiency side, the outperformance is explained by market participants mispricing the value of these companies, which provides the excess return in the long run as the value adjusts.
While I don't believe markets are completely efficient (too much proof outlining the opposite), I do believe markets are generally pretty darn good at eliminating blatant inefficiencies once discovered. 

What happens when inefficiencies are identified? 

Investor flows come in eliminating the inefficiency and the plain vanilla version of the value factor (price to book) appears to be no exception. Between 1995 and the end of 2014, the amount of money allocated to passive large value funds / ETFs grew more than 30% compounded / year, growing from slightly over $1 billion to more than $180 billion (and this doesn't include the MASSIVE amount of institutional separate accounts that went this direction), while small value went from literally $0 indexed to $18 billion in funds and ETFs. Including active managers, large / small value fund / ETF AUM grew from $86 billion to more than $1.1 trillion over that time frame.

The declining value premium

Below is a long term chart of the difference between the cheapest and richest stocks by book-to-market (the Fama French size factor) over rolling twenty year periods (20 years as this closely matches the time frame since the 3-factor white paper was published). While not necessarily completely dead, there is a material decline.

And how has this translated to index performance? Well, over shorter time frames, the results are even more striking (investor performance is similar in that the average "dumb" growth investor has outperformed the average value investor over these periods, despite a larger behavioral gap in growth than in value).

As of February 28, 2015

Even the best value investor of our time has seen massive compression in his ability to outperform (pulled from the always great blog A Wealth of Common Sense).

Is the value premium dead? 

Despite all of the above, in my view... absolutely not. What I feel is dead is an investor's ability to capture the value premium by simply allocating to companies with lower price multiples, ignoring all other fundamental aspects (growth, competitive landscape, etc...). In other words, like anything else in investing that becomes well known, the ability to outperform requires skill as the low hanging fruit of value may be dead.

Additional note: I find it utterly fascinating that those investors who believe active management is dead, pointing to the underperformance of passive over the last 5+ years as proof, are in many cases the same investors that believe value works, but it just needs "more time" or a different screen than book to price (the latter being an "active" decision). 

Friday, March 27, 2015

Your Bond Allocation Doesn't Matter as Much as You Think

Quick... which of the three allocations A, B, or C is 60% S&P 500 Index / 40% Barclays U.S. Aggregate Bond Index,  55% S&P 500 Index / 45% Barclays U.S. Corporate Bond Index, or 62% S&P 500 Index / 38% Barclays Treasury Bond Index going back all the way to the inception of the Barclays U.S. Aggregate Bond Index in 1976?

Tough right? How about a chart of a growth in $1 invested in each of the allocations

Still nothing? That's because you can access credit risk two main ways... through stocks or through spread, while rate exposure at the end of the day all comes back to rates on Treasury bonds. An allocation with a higher equity tilt, balanced with bonds with no credit risk (i.e. a pure Treasury allocation) provides the same exposure (and returns) over time as one with a lower tilt towards stocks with additional credit coming from spread.

So what?

While I do think there are times when there are more attractive means of gaining credit exposure through stocks, investment grade bonds, high yield bonds (a simple model I presented back in 2010 highlights how this might add value), you need to make a material reallocation to move the needle. On the other hand, a buy and hold investor can and should allocate to credit and rates in what is the most: (1) structurally efficient (i.e. minimal transaction costs), (2) cost effective (i.e. cheapest), (3) tax-efficient. 
  1. Structurally efficient: stocks and treasury bonds both trade at much tighter bid/ask spreads than corporate bonds. More important, during periods of stress, treasuries are MUCH more liquid - winner: stocks and treasuries
  2. Cost effective: interestingly enough, the cheapest treasury bonds ETFs are slightly higher in cost than the cheapest Aggregate Bond ETFs, but both are slightly higher than ETFs for the S&P 500; either way, we're talking bps here - a wash
  3. Tax-Efficient: the more you are allocated to stocks, the more tax efficient you become as capital gains are taxed at a much lower rate than bond coupons - winner: stocks and treasuries
Takeaway... while stocks balanced with treasuries may have a slight edge in terms of implementation, at the end of the day, it really doesn't matter. If you are spending too much of your investment time trying to decide whether to slightly change your bond allocation away from treasuries to another duration sensitive area of the bond market given fears of a rate hike, please spend your time elsewhere.

Footnote: I initially listed what allocations A, B, and C were... then I remembered it doesn't matter.

Wednesday, March 25, 2015

Fearful of Rising Rates? Stocks Have You Covered

Josh Brown (i.e. The Reformed Broker) has a nice piece questioning the merit of unconstrained bond funds. Embedded within that article was this gem:

In fact, since 1976, U.S. stocks and bonds have not declined at the same time for more than two consecutive months. Over the last 60 years, there’s only been one year in which both stocks and bonds posted an annual decline (1969).
You can actually make a bolder statement than that given that the Barclays US Aggregate Index' inception wasn't until 1976. The S&P 500 and "Agg" have never declined at the same time for more than two consecutive months. As surprising to me was that stocks and bonds on a stand-alone basis have only declined more than two straights months about 5% of the time (i.e. once every year and eights months).

So if rates rise from here (negatively impacting bonds), how will stocks perform? I'm glad you asked.

Jeremy Schwartz (@JeremyDSchwartz) outlined a few months back during a back and forth that stocks (especially small cap stocks) have historically performed very well during periods of rising rates... going back all the way to the 1950's.

Taking that one step further, the below breaks out performance by small, mid, large across value and growth during periods of rising rates since 1994 (I can only get daily Russell data going back 20 years). In this case, rising rates is defined as periods where the 10 year Treasury rose more than 100 bps without a 50 bp decline (there have been 9 such periods since 1994). Not only have stocks broadly performed exceptionally well in these periods (with small caps outperforming), growth stocks have performed even better (the less "bond-like" the stocks, the better the performance in rising rate environments).

For those fearful of a sell-off in rates... what to do? Well, if history holds, simply hold a balanced portfolio consisting of stocks and bonds. Want to be bolder? Tilt slightly towards small and/or growth. As for unconstrained bonds... let investment managers fleece you somewhere else.

Source: Russell, S&P, Barclays

Monday, March 23, 2015

The Benefit of Slowing Down the Rebalancing Process

One of the top Google “rebalance free lunch” results is an article quoting one of the brightest minds in finance, Clifford Asness, that I think most investors would agree with:

"Rebalancing is one of the few free lunches out there," said Clifford Asness, managing principal of New York hedge fund AQR Capital, in a recent interview with the Online Journal. "You're generally selling things that have gone up the most and buying things that have gone down the most."

While the article is from 2004 (and he may have changed his tune), I like that he felt rebalancing was a free lunch despite the strong research he has done over the years specific to momentum, something he acknowledges the rebalancing process eliminates in the same article:
 "Someone who doesn't rebalance is a tacit momentum investor." 

The key points in my mind as to why rebalancing may not be a free lunch:
  1. Momentum works: much research exists outlining that momentum can improve risk-adjusted performance (here is a great white paper by Cliff Asness himself)
  2. Relative outperformance doesn’t equal a relatively more expensive asset: quite simply, stocks SHOULD outperform over time as they can grow their earnings, while bonds pay a static coupon. So rebalancing doesn't always mean selling high and buying low.

It would be good enough if slowing down the rebalancing process did not materially hurt performance, as there are significant benefits associated with slowing down (lower transaction costs, tax benefits through delayed capital gains, and any behavioral benefit of looking at your account less often), but rebalancing less has actually improved average results specific to a 60% S&P 500 / 40% Barclays Aggregate Bond index since the latter’s 1976 inception with seemingly more potential outperformance than underperformance over any 36-month iteration.

Source: S&P, Barclays

Friday, August 3, 2012

Employment Survey's Diverge

The Washington Post details:

One is called the payroll survey. It asks mostly large companies and government agencies how many people they employed during the month. This survey produces the number of jobs gained or lost. In July, the payroll survey showed that companies added 172,000 jobs, and federal, state and local governments cut 9,000.
The other is the household survey. Government workers ask whether the adults in a household have a job. Those who don’t are asked whether they’re looking for one. If they are, they’re considered unemployed. If they aren’t, they’re not considered part of the work force and aren’t counted as unemployed. The household survey produces each month’s unemployment rate.

In July, the household survey showed that the number of people who said they are unemployed rose by 45,000. In a work force of155 million, that doesn’t make a big statistical difference. But it was enough to raise the unemployment rate to 8.3 percent from 8.2 percent in June.

Unlike the payroll survey, the household survey captures farm workers, the self-employed and people who work for new companies. It also does a better job of capturing hiring by small businesses.
But the household survey is more volatile from month to month. The Labor Department surveys just 60,000 households, a small fraction of the more than 100 million U.S. households.
Looking at the data, the household survey was even worse than that. Not only did the number of unemployed rise by 45,000, the number leaving the workforce spiked (resulting in the number employed dropping significantly), resulting in the unemployment rate rising despite the better headline number.

Source: BLS

Friday, July 27, 2012

GDP Expands 1.5% in Q2

Bloomberg details:

The U.S. economy expanded at a slower pace in the second quarter as a softening job market prompted Americans to curb spending.

Gross domestic product, the value of all goods and services produced, rose at a 1.5 percent annual rate after a revised 2 percent gain in the prior quarter, Commerce Department figures showed today in Washington. The median forecast of economists surveyed by Bloomberg News called for a 1.4 percent increase. Household purchases, which account for about 70 percent of the world’s largest economy, grew at the slowest pace in a year.

Consumers are cutting back just as Europe’s debt crisis and looming U.S. tax-policy changes dent confidence, hurting sales at companies from United Parcel Service Inc. (UPS) to Procter & Gamble Co. (PG) Cooling growth makes it harder to reduce unemployment, helping explain why Federal Reserve Chairman Ben S. Bernanke has said policy makers stand ready with more stimulus if needed.
Looking at the data, we see the declining contribution by consumption, offset in part by a quarter over quarter (small) rise in investment and a less negative impact from government cuts (i.e. addition by the elimination of subtraction). Overall, considering what was going on during Q2 this report isn't awful, but certainly isn't encouraging considering we are now three years out of the recession.

Source: BEA

Thursday, July 19, 2012

Leading Economic Indicators Decline by Most Since Last September

Bloomberg details:

The index of U.S. leading economic indicators fell more than forecast in June, a sign the U.S. economic expansion is slowing.
The Conferences Board’s gauge of the outlook for the next three to six months decreased 0.3 percent after a revised 0.4 percent increase in May, the New York-based group said today. Economists projected the gauge would drop by 0.1 percent, according to the median estimate in a Bloomberg News survey.

Source: Conference Board

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