May 9, 2011
"The reality of risk is much less simple and straightforward than the perception. People vastly overestimate their ability to recognize risk and underestimate what it takes to avoid it; thus, they accept risk unknowingly and in so doing contribute to its creation.
"Risk arises as investor behavior alters the market. Investors bid up assets, accelerating into the present appreciation that otherwise would have occurred in the future, and thus lowering prospective returns. And as their psychology strengthens and they become bolder and less worried, investors cease to demand adequate risk premiums. The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it.
"People often say, 'It's not cheap, but I think it'll keep going up because of excess liquidity (or any number of other reasons). In other words, they say, 'It's fully priced, but I think it'll become more so.' Buying or holding on that basis is extremely chancy, but that's what makes bubbles. In bubbles, infatuation with market momentum takes over from any notion of value and fair price, and greed (plus the pain of standing by as others make seemingly easy money) neutralizes any prudence that might otherwise hold sway."
Howard Marks, The Most Important Thing
Just a note - Howard Marks is the head of Oaktree Capital Management, and wrote his new book, The Most Important Thing at the behest of Warren Buffett. Though the bulk of Oaktree's business is in high yield debt, distressed debt, and private equity, the book is packed with insightful lessons for investors in most other markets as well. Included are many quotes from Marks' client letters over the years. If you read them carefully with attention to their dates, you'll notice that a great many of them would have been largely dismissed by investors because they were warnings against ongoing speculation - both in the late 1990's and in the 2004-2007 period. Though Marks' focus on value and risk management leaves little room for other quantitative investment methods and tools that I believe are useful - particularly those based on market action, internals and trend-sensitive indicators - I am convinced that most trend-followers pay far too little respect to value and true risk management (apart from, say, selling when prices break some moving average), so this book will be a great benefit to quantitative and technical investors as well.
You won't find much in the way of specific models or methods, but the perspectives on value, risk and prospective return are outstanding. For long-term readers of my own market comments, you'll see a lot of familiar themes. Marks views the ultimate investment error as "reaching for return" when markets are not priced to deliver them, and quotes Peter Bernstein, who said "The market's not a very accommodating machine; it won't provide high returns just because you need them."
With valuations now pushing the levels we observed in 2007 (not to mention 2004-2006), it is clear simply from a valuation standpoint that investors are unlikely to be rewarded by "reaching for return" - even if the progress of the market remains positive or stable for a while longer. With respect to the gradual resolution of present credit conditions, Marks had this to say in a CNBC interview Friday:
"We've gone through a period - I've been in this business for 42 years - that has primarily been a period of great prosperity. My essential underlying assumption is that the coming years will not be as prosperous as the last decades of the 20th century were. Incomes were stagnant during that period. GDP grew healthily. What bridged the gap between incomes and GDP was the extension of credit, and I don't believe that there will be a comparable increase in the use of credit in the next 10 years."
One of the ways investors can think about prospective return and risk is from the standpoint of the "Capital Market Line," which essentially lays out a menu of investment possibilities at various levels of return and risk. In theory, investors like to believe that this menu is always a nice, positively sloped line, where greater risk is associated with greater prospective return. And somehow, regardless of where market valuations are, investors often seem to believe that 10% is "about right" for the prospective return on stocks.
As it happens, however, valuations exert an enormous effect on the prospective returns that stocks and other investments can be expected to achieve over periods of say, 7-10 years, and those figures vary a great deal. The menu is often anything but a straight line, and sometimes fails to have any upward slope at all. There are certainly shorter-term factors that can keep the market at rich valuations over periods of several quarters, and in rare cases, a few years, but this doesn't change the mathematics of long-term returns.
For 5-year bonds or 7-year, high-quality corporate debt, you can essentially read the expected return directly from the yield to maturity. For long-term investments, like 30-year Treasuries or the S&P 500, there is somewhat more modeling required, but it should be clear from our standard methodology of estimating 10-year equity returns that valuations are extremely important in explaining the long-term total returns that investors subsequently achieve. Presently, our estimate of expected 10-year total returns for the S&P 500 is just 3.4% annually. The probable returns that were built into stock valuations in early 2009 have been compressed into the recent advance. Since 2009, to use Howard Marks' words, investors have "bid up assets, accelerating into the present appreciation that otherwise would have occurred in the future, and thus lowering prospective returns."
To illustrate how the menu of investment options has varied over time from an expected return/risk perspective, the chart below presents the menu that we estimate was available at a number of points in time. For 30-year Treasuries and the S&P 500, the expected return estimates use a 10-year investment horizon. I've included the profiles for August 1982, March 2000, August 2007, March 2009, and today.
Note that all of the figures in the chart below are prospective returns based on data that was available at the time (though it should be clear from the chart above that actual subsequent market returns have closely tracked the projections from our standard methodology, which is described in detail in numerous previous market comments). Again, for securities with maturities up to 10-years, prevailing yields-to-maturity are sufficient. For the S&P 500 and 30-year Treasury, the chart uses prospective returns based on existing valuations. So the figures for the S&P 500 below, for example, map to the expected returns from the model presented above.
Notice that 1982 was really a once-in-a-generation investment opportunity from the standpoint of long-term assets. On the basis of well-defined relationships between valuations and subsequent market returns, stocks were priced to achieve total returns approaching 20% annually for a decade. In fact, they followed with compound annual returns of nearly 20% over the next 18 years.
Unfortunately, the rapid returns of the S&P 500 in the late 1990's exceeded those that stocks were actually priced to achieve, and therefore were "borrowed" from the future. By early 2000, the S&P 500 was priced to achieve negative 10-year total returns for the first time since 1929. Treasury and corporate bonds, however, were still priced to achieve reasonably positive returns in the 6-8% range. This was no secret to value-conscious investors. Then again, Jeff Vinik, who managed Fidelity Magellan, acted on this fact too early in the late-1990's market bubble as prospective 10-year market returns dropped toward zero. Though bonds soundly outperformed the S&P 500 over the following decade, the shift was seen as inappropriate for a fund intended to closely track the market, and Vinik was replaced.
Though the 2000-2002 decline cleared a good portion of the extreme overvaluation (and allowed us to remove about 70% of our hedges in early 2003), it certainly did not take stocks to a level that could be viewed as historically undervalued. By 2007, the S&P 500 was priced to achieve prospective 10-year returns of less than 3%, while the prospective returns for bonds were scarcely above 5%.
The subsequent market decline, which took stocks down by more than half by March 2009, brought 10-year prospective returns for the S&P 500 modestly above 10% annually. I've regularly discussed the challenges of this particular cycle, particularly the need to contemplate credit-crisis data outside of post-war period (even after prospective returns exceeded 10% in the Depression period, stocks dropped by another two-thirds). With the methods we had available in 2009, we could not rule out substantially lower valuations (and far higher prospective returns). Still, my impression is that the snapshot of 10-year expected returns we observed in 2009 will probably turn out to be quite accurate when we look back in 2019. Meanwhile, the flight to safety in Treasuries, coupled with concern about credit risk in corporate debt, created an unusual hump in prospective returns for bonds, with corporate yields about twice the level of long-term Treasury debt, despite historically lower volatility.
The blue line on the graph presents the current menu of options available to investors. Importantly, except when one moves immediately away from Treasury bills, where the 3-month T-bill is now priced at a yield of 0.02%, the tradeoff between prospective return and risk has no positive slope at all. 10-year Treasury debt yields 3.16%. Corporate debt (as measured by the Dow Jones Corporate Bond Index) is priced to achieve returns of just 3.63%. Based on our long-term bond models (which factor in yield curve rolldown, real-interest rate reversion, and other considerations), 30-year Treasuries can be expected to achieve total returns of about 3.60% annually (though a sustained inflationary spike would worsen returns in the next decade and increase them in the out years), and we estimate that the S&P 500 is priced to achieve 10-year returns of about 3.43% annually.
All of these prospective returns are nominal. In real, after-inflation terms, they translate into an expectation of near-zero real returns over the coming decade. From the standpoint of pension funds and endowments, the current profile of expected returns is of great concern, given that few corporations, states, universities or charitable foundations have lowered their long-term return assumptions from the 7.5%-9.5% range. This means that we're likely to observe increasing budgetary strains from underfunded pensions and endowments in the years ahead. Much of this is thanks to policies that have regularly aimed to distort valuations and have needlessly encouraged the allocation of scarce savings toward inefficient and often reckless uses.
The impact of the Fed's policy of quantitative easing has not been to increase "wealth" upon which a future consumption stream can be based. Instead, the effect of QE has been to increase valuations - producing high short-run returns by borrowing from long-term prospects. This has now produced a degenerate menu of long-term investment options (for passive investment strategies). Quantitative easing cannot produce wealth - it can only shift the profile of returns from the future to the present by forcing all assets to compete with zero-return cash. Now that it has done so, it is urgent for investors to weigh the prospective returns that remain, against the likely long-term risks.
Needless to say, I do expect that greater prospective returns are possible from investment strategies with the flexibility to vary their market exposure and asset allocations over time, and to some extent, from certain sub-categories of stocks (particularly large-capitalization stocks with stable-revenues, clean balance sheets, and non-cyclical margins). Still, it is not possible at the aggregate level for all investors to enjoy above-market returns from asset allocation.
So the challenge - and success strategy - for investors will be to accept much less exposure to market risk when it is priced to achieve poor long-term returns, and to expand their exposure to market risk when it is priced to achieve strong long-term returns. At present, the weight should move toward defensive strategies, though as I noted earlier, investors should be mindful that long-term prospects don't cleanly resolve into short-term outcomes. Despite the challenge in the recent cycle of having to contemplate Depression-era risks, none of the lessons we've learned suggest that valuations have become unimportant. Investors should understand that attention to valuation and risk-management are likely to be their greatest assets as they address the low-return investment menu that is presently available, and the changes that will be offered in that menu as the coming years unfold.
As of last week, the Market Climate for stocks remained characterized by an overvalued, overbought, overbullish, rising-yields syndrome that has historically been hostile for stocks. Still, given that we had the opportunity two weeks ago to raise the strike prices of our put options in Strategic Growth as the market pushed against every upper trading band (daily, weekly, monthly), last week's selloff put those puts in the money, and gave us an opportunity to cover about 30% of our short-call option position while still retaining strong downside protection. Strategic International Equity remains tightly hedged here as well.
The shift in Strategic Growth will be helpful primarily if the market advances more than a few percent, at which point our put options would go back out-of-the-money, leaving us with a roughly 30% unhedged position coupled with a tight "safety net." Ideally, though, we would prefer for the stock market to "clear" the present condition with a larger decline, a retreat of advisory bullishness, a clear reversion to falling interest rates, or ideally all of these. At that point, we could drop our put options from in-the-money to slightly out-of-the-money, giving us a greater exposure to market fluctuations but retaining something of a "line-in-the-sand" if the market was to experience extended weakness.
My longer-term view is clearly cautious, particularly given the syndrome of hostile conditions I noted last week (see Extreme Conditions and Typical Outcomes ). Still, those conditions have more consistent importance for intermediate- and long-term market outcomes than they have, on average, over the following 3-6 month period. In some cases, such as 1987, the short-term outcome was very severe. But given the variability, my impression is that the best approach is to maintain a willingness to accept market exposure provided that we clear some component of the present hostile syndrome, but also to retain a safety-net using a line of out-of-the-money put options to defend against market losses that might emerge more quickly.In bonds and precious metals, we observed a slight improvement in market conditions last week. For bonds, this was due to some general weakness in economic reports, relative to expectations, which eased the upward pressure that we had previously seen in Treasury yields and - given that the weakness was not enough to create credit concerns - also eased the pressure on corporate yields. In precious metals, the selloff in gold and silver was modestly constructive in that it moves us closer to the point where we would be willing to re-establish some of the exposure we cut previously. The breathtaking plunge in silver prices was a wonderfully instructive example, I thought, of what happens when a Sornette-type bubble hits its "finite time singularity" (see Anatomy of a Bubble ). Strategic Total Return presently carries a duration of about 2.7 years, with about 5% of assets allocated between utility shares and precious metals shares.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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