“A groundhog is like most other prophets;
it delivers its prediction and then disappears”
In our office we frequently make sport of the countless headlines we encounter on a daily basis from various media outlets across the web. These headlines are often splashed across the “home” pages of market or financial sites—though often across mainstream “news” outlets, or the business sections of Sunday newspapers as well. Usually in 48-point font, they include such intellectually enticing teasers as; “5 Reasons to Flee the US for Canada”, “11 Things You Need to do to Protect Yourself from the Coming Crash”, or “Time to Ditch Rising Stocks, or Stick With Them?”. Of course rarely does a click-through to the article reward the reader (or surfer) with cogent, reasoned and researched financial advice (which by definition cannot be disseminated to a mass-market audience). More often they are simply an amalgam of quotes and predictions from like-minded money managers, economists, or academics; perhaps with a particular trading position to justify, axe to grind, or perhaps simply the desire to raise their profile as a sought-after commentators. Not to worry of course, the following days or weeks will present us with “Why this Bull Market has Just Begun”, or “7 Stocks You Need to Own Before Christmas” (and as an aside…why always a prime number?).
The real trouble, it seems to us, is that in today’s information-saturated society, many—perhaps even most people have come to conflate headlines with actual news, rarely “clicking through” to understand that no notable conclusions have been offered; or they may absorb the splashy headline prediction of a crash one day, but miss the splashy Bull-Market prediction the next. We arrive at this theory in-part because we, like most advisors, are the recipients of sometimes concerned, sometimes panicked phone calls from clients who may feel they’ve alighted on an opportunity to save themselves considerable financial heart-burn. Frequently, these headlines are highly correlated with the short-term direction being pursued by the stock market; a three-day down draft in the S&P 500 is often accompanied with negative “news” headlines—and the phones become more active.
David Edwards of Heron Financial, an unaffiliated investment advisor, wrote in a newsletter last month;
“US stocks as defined by the S&P 500 made 31 record highs in 2014, most recently
through July 24th. Through Friday afternoon stocks declined by 3.3%….Fox and CNBC
declared an apocalypse because of an increase in e-mails and phone calls….
The CNN Money Fear and Greed Index swung to “Extreme Fear” from last month’s “Extreme Greed”.
He went on to describe how a long-time client had called to complain about a “$44K paper loss” during this market volatility—never minding that the client’s $2 million portfolio was up $117K year-to-date. Thankfully, we can say our clients have been comparatively more circumspect—but Mr. Edward’s anecdote dovetails with our own experience, and doubtless that of most advisors. We attribute much of this general behavior to the “CNN Money Fear and Greed” indexes of the world. The internet, after all, competes for eyeballs alone. Like Punxsatawney Phil—the prophets who write the headlines never concern themselves with accuracy, and rarely revisit their prediction failures.
Of course we do pay attention to very well-informed opinion, particularly from those with “skin in the game”—and what strikes us today is the divergence of opinions among market strategists on the topic we’ve been commenting on in our Outlooks and client reviews for most of the last twelve months; that of current stock valuations.
By now the refrain should be familiar; stocks are “not cheap”. But neither is the most frequented alternative to stocks—bonds. In fact, from a historical perspective, one could argue that stocks are much “cheaper” than bonds. Adding fuel to this debate, renowned Yale economist and Nobel Prize winner Robert Shiller recently opined that stock prices are dangerously overvalued. Shiller cites his own so-called CAPE index, a cyclically adjusted P/E index whereby the denominator is measured using mid-business cycle earnings averages over the last 10 years (rather than most recent year’s earnings, or earnings forecasts). This measure, he tells us in an Aug. 16 New York Times article, has reached a “worrisome level”, a level which preceded 1929, 1999 and 2007. However, Burton Malkeil, author of the best-selling A Random Walk Down Wall Street points out in an Aug. 27 Wall Street Journal piece; “The CAPE does a reasonably good job at predicting 10 year equity returns. High CAPEs predict low future returns…The CAPE is not useful in predicting returns one or two years into the future.”
Malkeil goes on to point out what we mentioned above, and have alluded to frequently over the last year, and that is that “the main competitors for stocks in individual and institutional portfolios are bonds”, and it is almost universally agreed that bonds, in general, have little upside beyond the low coupon rates they currently pay.
We have surveyed market perspectives from most fund families we do business with—and many we do not. Key themes range from “the US expansion remains intact”, to “the current market rally is getting old” to “large caps tend to lead later in recoveries”. Frankly, we agree with all of the above. There is no doubt that measures of equity valuations are all trending to the upper end of their normalized range—but there (finally) is little doubt, based on Q2 revised GDP of 4.2% that the economy is growing, and that jobs are being created. Richard Skeppstrom of Eagle Asset Management answers the proclamation put forth by Robert Shiller’s CAPE calculations saying it “reflects the fact that margins are at all-time highs. If one adjusts the denominator lower under the assumption that earnings are overstated, then naturally one gets a higher price-to-earnings (P/E) ratio as a result”. To paraphrase, US corporate profit margins are at record highs, which explains much of the stock market rise over the last 18 months. Adjusting earnings for cyclicality given current profit margins is, in fact, adjusting earnings downward from their current level, and results in Shiller’s very high CAPE ratio.
Finally, and speaking of prophecies, we recall the 2010 thesis put forth by PIMCO’s Bill Gross and Mohamed El-Erian which was titled “The New Normal”. Back then there were widespread expectations of an imminent interest rate hike as financial asset prices rocketed off their 2009 lows. The US was technically coming out of recession—and concerns were high that inflation was inevitable due to the Fed’s historically unprecedented accommodation. The “New Normal” thesis held that for a variety of economic reasons, interest rates would remain extraordinarily low for a protracted period of time. As far as predictions go—this one was spot-on. As of August, we have had 68 months of a 0% Fed Funds rate, and four years of “quantitative easing” on top of that.
This Spring, PIMCO’s updated Secular Outlook is titled “The New Neutral”. The premise can be boiled down to their expectation that while interest rates will indeed rise, global central banks will likely be targeting real policy rates of 0%-2% (translating into nominal policy rates of 2%-4%), much lower than the return to “normal” expected by much of the market and many market commentators (2%-4% real, 4%-6% nominal). PIMCO’s William Benz, CFA explains the investment implications over the long term:
Bond and equity market returns will likely average a more modest 3%-5% in this
environment, though risks will be lower as well. This doesn’t signal an end to volatility;
it just means bond yields are unlikely to increase much above current forward rates,
while equities and other risk assets remain relatively range-bound….in a world of
lower expected market returns, or beta, every basis point matters….our concern is that
future returns will not only be lower than in the most recent past but will also fall
short of what most investors need and expect.
Let us summarize our take on this myriad of investment opinion; Recency Bias is a behavioral finance term defined by the CFA Institute as “the tendency to recall recent events more vividly and give them undue weight…Research points to a tendency for individual private investors to extrapolate trends and to suffer more from recency bias…” Given the traumatic market events of 2008-2009, we believe the media outlets which produce so many absurd daily headlines are actually counting on recency bias to draw eyeballs to their websites. However it is important that investors not lose sight of actual economic facts when examining equity valuations; facts like the 4.2% GDP growth in the last quarter, record corporate profit margins, the sustained improvement shown in the Purchasing Manager’s Index (an amalgamation of market sector indicators), and of course the slowly improving labor picture this year in the US.
We’ve written recently that a near-term market correction is certainly possible—but given the underlying and improving fundamentals both in the US and globally, we do not anticipate the source of such a correction to be simply equity valuations. We’re reminded of a quote from famed money manager Peter Lynch a few years back;
Far more money has been lost by investors preparing for corrections, or trying
to anticipate corrections, than has been lost in corrections themselves.
Over the longer term, however, we recommend investors absorb the research done by Robert Shiller, the PIMCO Investment Committee, and several others not cited in this Outlook. Return expectations for the next 5 years or so—in both stocks and bonds should be adjusted downward from recent experiences. Our biggest concern remains the bond market’s ability to deliver anything beyond current paltry bond yields—and plenty of downside exists. And while equity markets should continue to plod ahead with global growth—that growth is not booming. The US remains the “cleanest shirt” in a pile of dirty laundry economically, but globally (including the US) economic growth is converging to a much lower level than has been experienced over the last forty years. True value in equities will be more often than not found outside the US.
Despite this nuanced tour of near-term market opinions and our own conclusion that equity valuations shouldn’t necessarily keep us up at night, CCR Wealth Management has made some recent, modest adjustments to our model portfolios;
- We have reduced small cap exposure in our models from 10%-12% of equities to 7%-8%, and are in the process of reviewing client portfolio small cap allocation levels. This is an acknowledgement that while we feel fairly comfortable with our position in the economic cycle, the market cycle is aging—and large-cap stocks tend to outperform later in the cycle. Small caps are also among the most richly valued equity categories.
- We have limited our high-yield bond component (specifically, dedicated high yield funds) within the fixed-income models to 10% of the total bond allocation. Realistically, several other bond portfolio components including our “core” bond funds have high yield exposure as well—so this adjustment will not actually limit high yield to 10% in most cases. High yield, like small caps stocks, are the most highly valued category within its asset class, and bonds in general are arguably overvalued relative to stocks.
In the “New Neutral” environment as foretold by PIMCO, investors will be stuck with total portfolio returns averaging in the mid-single digits, perhaps for a protracted period of time. In our January 2014 Outlook we introduced the concept of non-traded REITs as a viable alternative to stock and bond market exposure as a source of investment return. “Every basis point matters”.
The benefit of non-traded REITs as a component of a diversified portfolio are essentially two-fold; First, there is no correlation to equity markets or bond markets. While REITs are readily available as traded securities (and we in fact employ a REIT fund in many of our allocations), REITs which trade on the stock exchange have a correlation to the stock market which actually approaches 1 during downside market turbulence (i.e., they capture all the market downside). In contrast, the value of the commercial property down the street from you—be it an office building, drug store or hotel, does not drop in value just because the stock market had a tough week, month or even year. Non-traded REIT companies operate under the exact same business principals as their traded counterparts—with the exception that they are valued purely on the periodically updated valuation of their properties, rather than by the laws of supply and demand for their stock which may be in effect on any given day, week or year.
Secondly, as a source of return non-traded REITs generally pay 6%-7% dividends. This monthly income is rental income (or mortgage payments—depending on the type of REIT), made under long-term contracts. As such it diversifies a portfolio’s source of return.
As with most truly alternative investments, an investor must give up some liquidity to reap these benefits. These liquidity restrictions do limit the scope of investors for whom they are appropriate. CCR Wealth Management will be discussing non-traded REITs with clients for whom this diversification tool is appropriate in the months ahead.