Tuesday, December 5, 2017

Can Time Solve the Issue of High Valuations?

“Time solves most things. And what time can't solve, you have to solve yourself.” - Haruki Murakami 

Recent research by GMO outlined that wide profit margins, low levels of inflation, subdued economic volatility, and low 10 year treasury rates have led to high valuations for both U.S. stocks and bonds. Yet irrespective of why valuations are high relative to history, what an investor pays for a dollar of earnings or a dollar of bond coupons directly impacts the forward return they receive. This is generally understood by investors who have accepted the likelihood that returns will be low over the next five or even ten years. What has been discussed less, or often dismissed outright by buy-and-hold long-term investors, is the similar challenge investors may face over much longer periods of time given high starting valuations.

The Issue: Annualized Returns Can Mask the Effect of Compounding 

Annualized returns are commonly used to compare asset class performance over various time frames. The issue is annualized returns trivialize the effect of compounding, especially over longer periods. As an example, the following chart compares annualized returns for:
  1. an investment that is down -50% in year 1, which then returns 10% each year for the next 29 years
  2. an investment that returns 10% each year for the full 30 years 
We can see the large return gap between the two investments in year 1, as well as what appears to be a narrowing of that gap over time from a 10% annualized differential in year ten to a 3% annualized differential in year thirty. 

In reality, the return gap is getting larger in dollar terms as the same 10% earned each year after year one is from a much larger base for the investment that was not dragged down by the initial 50% decline.

A Revised Perspective

One way to view valuation of the U.S. stock market is the cyclically adjusted price to earnings “CAPE” ratio (a measure of the price an investor pays for each $1 of historical normalized earnings). This ratio can be converted to a yield by inverting it (i.e. a CAPE of 30x = 1/30x or a roughly 3% yield) as a means of making it more comparable with current bond yields. We can then calculate a yield for a traditional balanced 60% stock / 40% bond portfolio “60/40”, by using the formula ‘60% CAPE yield + 40% bond yield = 60/40 yield’.

This 60/40 yield has provided strong explanatory power for forward annualized ten year real (after inflation) returns going back to 1926 (Ibbotson data inception).

This 60/40 yield has also provided strong explanatory power for much longer 30-year forward annualized returns. The issue is annualized returns makes it appear that the range of outcomes, relative to starting valuations, narrows over longer periods of time, an argument commonly used by buy-and-hold investors. In reality, the comparison of annualized returns over different time frames masks the compounding effect of these seemingly small return differences.

The following chart removes this effect by showing the real growth of $1 for each these starting valuations over 10 and 30 years instead of annualized returns. We can clearly see that the gap in dollar terms widens significantly over longer periods, as the compounding effect has more time to work its magic.

The “we are here” line in this chart highlights how extreme current stock and bond valuations are relative to history, creating an environment where time itself may not be a solution to the valuation challenge.

 What Can an Investor Do? 

For an investor looking to improve their outcome, there are a variety of options available, including: ­
  1. Search for Value: reallocate capital to segments of the US equity market (or outside the US equity market) that may be more attractive ­
  2. Identify Alpha Opportunities: rethink the value proposition of active management, especially within less efficient areas of the market ­
  3. Follow the Trend: utilize trend following to manage equity exposure 

The first two options are familiar to most investors, but trend following may be less so. In a nutshell, trend following is simply a means of determining if you will own an asset based on its recent price history. One simple set of trend following rules are: ­
  • If the S&P 500 Total Return Index > 12-Month Moving Average, Own Stocks ­
  • Otherwise Own Bonds 

Given this simple trend following model can never result in monthly outperformance vs the S&P 500 when the market is up, as the most it can own is 100% stocks, it will underperform during most bull markets relative to the S&P 500. However, it may still outperform a 60/40 portfolio in these environments as it is not weighed down by an allocation to bonds. Conversely, the strategy will outperform the S&P 500 in down markets over time and, importantly, it has the potential to side step a major market correction that impairs the compounding effect that has historically impacted long-term returns when valuations have been elevated (more on why trend / momentum works here).

The below chart updates the 30 year real growth of $1 with returns for this basic trend following strategy, comparing the returns generated to the original 60/40 buy-and-hold portfolio over similar periods.

While there are still material differences in the historical growth of $1 depending on the starting valuation, the trend following strategy generated dollar growth that was consistently higher than that of a 60/40 strategy and produced returns that were higher even at low starting yields than that of a 60/40 portfolio at much higher starting yield levels.


Buy and hold strategies work best when stocks and/or bonds are cheap. When valuations are extended and starting yields are low, an investor should look to allocate to cheaper areas of the global market, rethink the value proposition of active management, and/or be prepared to reduce stock market exposure if profit margins, inflation, volatility of GDP, or 10 year treasury rates (that pushed valuations higher) reverse course.