Valuations Do Matter (Even Over Shorter Time Frames) / Momentum Driven Valuation Timing

I often read that valuations don't matter over the short-term (a case often cited against market timing). Over very short periods (hours, days, etc...) this certainly may be true, but while there can be a lot of variability around month-to-month or year-to-year performance, I completely disagree with the sentiment that it doesn't matter. That said, there are better ways than just using current valuation levels for an investor to time markets which I will outline below.

Debunking the Case that Valuations Don't Matter

Before getting into my analysis supporting the theory that valuations do in fact matter a LOT, especially when you use the information embedded in momentum as support, I did want to highlight a recent research paper / article outlining valuations don't matter that simply appears to be wrong. 

Larry Swedroe from ETF.com shared research in an article Valuation Metrics In Perspective outlining the research done by Javier Estrada which concluded that one year forward performance of the S&P composite from 1899-2014 was independent of preceding valuations:

when the current P/E was between 10.4 and 13.3, the one-year forward return was 7.3 percent. When it was higher, between 16.4 and 18.9, the one-year forward return averaged 11.7 percent. And when the current P/E was above 19, the one-year forward return averaged 10.0 percent.

While I completely agree that one year returns are noisier than 10 year returns, the above results truly surprised me. While any one year period could have much higher / lower returns (i.e. the range of outcomes should be wider), over long periods of time the average one year forward performance when valuations are cheap shouldn't be that different than the average 10 year forward performance (it should average out to roughly the same figure).

Given my surprise, I decided to recreate the results in the paper using Shiller CAPE for my P/E over that same 1899-2014 time frame. The results in the table below make it likely that the analysis in the paper is either flawed (they do use a weird 3-month lag for earnings) or is simply wrong (my personal view). As the table outlines, the results not only show that high valuations = lower returns over one year, but the average one year return is even more dependent on valuations (on average) than ten year returns. You can also see that the range of outcomes is much more dispersed over one year than ten years.

Back to the Original Point of the Post... Momentum to Time Value

I had run the analysis below prior to my attempt at recreating the above data, so my methodology is a bit different. In the example below, I use data going back to 1881 (which is aligned to the inception of the Shiller CAPE time series) and I separate one month forward returns by whether or not the S&P composite had a one year backward looking return that was positive or negative. Below are the same data points in a table form and in a scatter plot.

What is easily discerned is that regardless of momentum, cheap valuations are generally good for returns (though extremely cheap and negative momentum has had some severe volatility - see standard deviation for periods when CAPE < 10), while high valuations have generally resulted in pretty strong returns when momentum is strong. Valuations seemingly only matter when valuations are high and momentum has turned negative (as seen by the negative absolute performance for the three buckets when CAPE > 15 and momentum is negative).

My takeaway... the underlying trend of the market is often as, or more, important than stock price levels, but performance will eventually catch up with how much you paid. BUT, momentum may help protect an investor when markets are rich and turn, as well as help keep an investor appropriately in the market even when valuations appear stretched.

The Mean Reversion Case For (and Against) Strong Future Returns

Bull thesis: 15-year S&P annualized returns ending 9/30/15 came in at just under 4%. The average forward return since 1915 when returns were that level (or lower) was 15.5% annualized over the next 15 years with a standard deviation of only 2%

Bear thesis: the 15-year starting point came when the previous 15 year annualized returns were just under 18% (i.e. we are still working off extreme valuations)

The counter argument to the bear argument can be seen in the chart below which compares the same 15 year historical returns on the x-axis with 30 year forward returns on the y-axis. As outlined in my previous post, returns tend to smooth out over 30 years, thus it matters a lot less what you pay for stocks over 30 years than over 5, 10, or even 15 years because more of the return is composed of fundamentals (i.e. dividends, buybacks, etc...) than multiple expansion / contraction as compared to shorter periods. Thus even extreme valuations have historically delivered 30 year returns I think most investors would find acceptable at the moment.

My take? Right between the two. I am not nearly as scared by current valuations, peak margins, etc.. as bears (especially over longer time frames) and I am not remotely a bull either. That said, I'm also not worried about a short term correction that would likely create a much better buying opportunity in the future.

Making Time (Even More of) an Investor's Best Friend

Ben Carlson of A Wealth of Common Sense blog (and author of a great book by the same name), had a recent post Playing the Probabilities outlining that time has been an investor's best friend (for those investors that have had in some cases quite a bit of time), pointing to the following table.

He also shared some pretty amazing stats, including:

The worst total return over a 20 year period was 54%. But the worst 30 year total return was 854%.

While I certainly agree with everything he outlined, he did ask the following question.

Has anyone figured out a better way of compounding your money in stocks beyond increasing your holding period? Not many.

Challenge accepted!

Simple rules (for more... see Meb Faber's record downloaded white paper):

• If the S&P composite TR is > 10 month moving average, stay in stocks
• If the S&P composite TR is < 10 month moving average, move to bonds (in this case 10 year treasuries)

The equity curve.

And the updated table with some additional bells and whistles (note there are some very slight differences with the returns Ben produced, but the message is identical).

While there is no free lunch (in this case, an investor gives up some upside over shorter time frames), using these basic momentum rules resulted in no negative returns over any ten year period and actually increased the long-term returns over this 1926-2015 time frame, making time an even better friend for an investor.

GMO Flows Turn Negative - An Ominous Sign for Risk Taking

As unnecessary as it may seem, contrarian investment managers need to be even more consultative with their clients than managers more aligned with market sentiment, otherwise clients won't be able to handle the extended periods of relative underperformance a contrarian investor is likely to face from time to time. In the case of GMO, while the long-term performance of many of their strategies is pretty strong (and tend to materially outperform when markets turn), the performance captured by their investor base is typically quite poor.

One example being the GMO Benchmark Free Allocation III, a fund in which the average investor has underperformed the fund by 3-5+% over 3, 5, and 10 years. As a result, despite a 16th percentile Morningstar rank in terms of fund performance over 10 years, investor performance only ranks 74th.

In other words, their investor base historical zigs when they should zag... adding money to the contrarian GMO after markets have tanked (when they should be taking market risk) and piling out of the contrarian GMO after markets perform well (when they should be taking risk off the table). Thus, it was relatively alarming to see that funds flows at GMO have been negative $4.2 billion over the twelve months through 9/30/15, including almost $3 billion of outflows the last two months of the third quarter alone.

How poorly have investors timed GMO? Let's take a look at how well a model doing the exact opposite of GMO flows would have performed going back 20 years.

Rules:

• If twelve month flows to GMO funds are positive, allocate the next month to stocks (S&P 500)
• If twelve month flows to GMO funds are negative, allocate the next month to bonds (Barclays Agg Bonds)

The result of which is more than 100% of the S&P 500 with almost half the volatility and drawdown.

I have a ton of respect for the way in which GMO manages money (their guts to be massively contrarian if that is their view) and I think their thought leadership is about as good as it gets in the industry. The challenge is GMO knows they are smarter than their clients, leading to a more-or-less 'take it or leave it attitude'.

But what good are strong long-term returns if an investor is unable to capture them?