We thought we would do things a little differently this week. As a research driven firm, we spend a lot of time reading, from books to research papers to blogs. This week, we thought we’d focus on some of the great content we’ve read in the last few weeks.
A stormy forecast for stock returns
Being a quantitative firm is not an excuse for not understanding the macro-economic conditions in which we live.
In his blog post “P/E Ratios – You’re Doing it Wrong”, Jordan Terry from Stone Street Advisors breaks down the varying fundamental components that go into a P/E ratio (free-cash flow, cost of equity, and growth rate) and explores the impact a change in that component can have on the resulting P/E. Taking current cost of equity estimates and P/E levels, Jordan estimates that the current price of the S&P derives a forward growth rate of just 4.5%.
The anonymous blogger Jesse Livermore took a very different path but reached the same conclusion in “Capital Recycling at Elevated Valuations: A Historical Simulation”. Jesse points out that over the long run, dividends reinvested into the market have made up over 73% of total returns. The valuation at which those dividends get reinvested can have a dramatic impact on what the forward return ends up being. With today’s elevated valuation levels, we get a forward 10-year return forecast of 4.27-4.72%.
So if US Stocks are expensive, what do we do?
That’s the question that Mebane Faber asked himself in a recently penned blog post. numbers behind some pretty common sense results:
- When US stocks go down, global stocks go down
- Bonds can protect, but only do so a little more than half the time
- Cash is king for capital preservation, but not for hedging
- Commodities are too volatile and random to rely on
- Managed futures – i.e. trend following – is the best, but pre-1980 numbers are mostly hypothetical.
Meb ultimate argues that a 1/3rd investment in stocks, bonds, and trend-following strategies is completely reasonable.
Trend following and ...
Bhansali, Davis, Dorsten and Rennison recently authored a white paper at PIMCO that explores how trend and carry influence returns across different asset classes and timeframes. Carry is the expected return of an asset class assuming market conditions and the asset’s price stay the same. For example, this may be the dividend yield on a stock or the yield-to-maturity of a bond.
The research paper highlights that for almost all asset classes, the most favorable regime for returns is positive trend and positive carry.
Larry Swedroe does a great high-level breakdown of the paper over at ETF.com.
Our Multi-Asset Income strategy embraces a similar approach, incorporating only positive-trend assets and tilting towards those with higher risk-adjusted carry. With the forecast for stocks and bonds fairly repressed in the next decade, higher carry assets can serve as an alternative source of return potential.
Not all tactical strategies are created equal
So trend-driven and other tactical strategies may play a crucial role in helping investors navigate the next decade – but not all tactical strategies are made equal.
Josh Brown – a.k.a. “The Reformed Broker” – penned an excellent piece this week called “How We Do Tactical”. In our opinion, it’s an instant classic. We’ve never read a piece that so well articulated with our own philosophies regarding tactical investment methodologies. To highlight a few key quotes that really resonated with us:
- “While we don’t attempt to predict the future, we do analyze the present and calculate probabilities from the past. We prize evidence over excitement and durability over everything.”
- “[W]hen we set about building our own tactical model, the central objective was to come up with reasons to trade as infrequently as possible – and to make every buy and sell count.”
- “Our tactical methodology, then, is based on isolating the potential for when a 5% dip may become something more. We can’t predict in advance, obviously. We can calibrate our reaction, though, and we do so based entirely on price and trend inputs. Goaltender does not utilize emotion, instinct, opinion, narrative, gut feelings, political leanings or hopes and dreams.”
Increased sensitivity is not increased safety: a picture is worth 1000 words
In his article, Josh references a study he had his firm’s director of research, Michael Batnick, conduct. The hypothetical investment strategy sold after every 5% market dip and bought in after the price had climbed to 1% above the sell-point. In his blog, The Irrelevant Investor, Michael summarizes the damages that an overly sensitive tactical strategy can have on a portfolio with a single, but powerful chart:
Tactical strategies are a balance between capital protection and market participation. Each objective, on its own, is trivial to solve. To protect capital, we could invest 100% in cash. To participate, we could invest 100% in the market. Meeting both objectives, however, is highly non- trivial. Historically, markets have gone up more than they’ve gone down – so worrying about protecting against every 5% dip can be catastrophic to long-term participation.
So embrace the trend – just be careful which one
A few weeks ago, we wrote a commentary about currency-hedged foreign equity exposure. Without a doubt, this has been the trend of the year among investors, with billions of dollars flowing into currency-hedged ETFs.
Our view was that currency hedging was appropriate if you had a view on the currency itself, but did not necessarily make sense as the de-facto exposure.
Catherine LeGraw recently wrote a white paper at GMO titled “The Case for Not Currency Hedging Foreign Equity Investments: A U.S. Investor’s Perspective” that puts some great analysis behind this new fad.
The big takeaways:
- Currency hedging is not hedging in the true sense: it just layers on a directional short currency position.
- It doesn’t make sense to hedge natural resource companies since their base currency is the commodity
- It doesn’t make sense to hedge multi-nationals since their exposure is multi-currency. In 2014, MSCI EAFE Domestic Sales by Country sits near 35% – versus over 60% in the early 1990s. In other words, globalization has dramatically reduced single-currency exposure.
- Exporting companies – those that produce goods and primarily sell abroad – have revenues in multiple currencies and benefit from a depreciating home currency.
- It may make sense to hedge currency exposure for foreign companies whose costs and revenue are entirely in a foreign currency. These companies represent only 15-25% of global equity market capitalization.
- Hedging currency exposure increases the correlation between domestic and foreign equity market returns over 5-year periods.
- Hedging currency exposure can actually increase tail risk, since we’ve layered on a directional currency short – creating a 200% notional exposure.
- Currency management can make sense in select cases, but carte-blanche currency hedging does not.
While the trend in 2015 has been heavily towards currency-hedged solutions, this may be one time where fighting the trend may make sense.
In Our Models
We rebalanced our Tailwinds Growth model this week to account for underlying changes and developments in our Multi-Asset Income sleeve.
The largest changes reflected an increased allocation to bank loans, convertible bonds, S&P 500 BuyWrite, and international REITs while reducing exposure to emerging market debt and corporate bonds.
These changes are largely driven by continued positive momentum in bank loans as well as shifting yield-to-risk metrics in the Multi-Asset Income universe.
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