With global stocks up approximately 25% from their Fall 2011 low and many market watchers from various financial media sources endorsing equities in recent weeks, it’s hardly surprising that investors are wondering if stocks are still a good bargain.
While some measures of sentiment – notably abnormally low volatility levels – could be interpreted as flashing yellow caution signs, valuations and fundamentals still favor global stocks over the long term.
Currently, equities look reasonably priced on an absolute basis. Developed market equities are trading at around 14.5x trailing earnings, while large emerging markets are trading at roughly 12x earnings. These valuations are significantly above those touched during last year’s trough, but both emerging and developed market stocks are now trading at a significant discount to their long term averages.
The relative case for stocks, however, is even more compelling as equities look very cheap compared to bonds. While equity valuations are modestly below their long-term average, bond valuations are significantly above theirs when measured by virtually any metric.
Nowhere is this more evident than in the U.S. Treasury Market. Late last year, the yield on the 10-year Treasury note dipped below the level of core inflation for the first time since 1980. Rather than paying investors the typical long-term average real yield of 2.5% to 3%, the US government is now paying a negative real yield to borrow. As a result, unless the US is sliding toward Japanese style deflation – and so far there is little evidence of this – US Treasuries look extremely expensive and investors in 10-year notes are accepting a loss in purchasing power and no real income. In addition, because coupons are so low, the duration or interest rate risk of Treasuries is at or near a historic high.
Some investors have weighed the volatility of stocks against the low yield on bonds and opted for a third choice: Cash. A tactical move into cash is certainly reasonable for brief periods of time. But if you’re worried about long-term purchasing power, having a significant, long-term allocation to an asset paying zero return makes little sense. Stocks are a more reasonable option to consider.
To be sure, investing in equities has its risks. Some have argued that equity valuations are flattered by historically high margins. But in the United States at least, a combination of just enough gross domestic product growth, anemic wage growth and low rates should support margins over the near term.
Among other risks, while US deflation looks unlikely, it’s possible and it’s a scenario that would clearly favor bonds. Under the opposite scenario – higher US inflation – equities would surely suffer thanks to lower multiples. However, in an inflation scenario, equities would likely hold up better than bonds or cash.
In short, equities may not offer the stellar prospects of the 1980s or 1990s, but absent a bout of deflation, stocks are likely to outperform the alternatives over the long term.
Saturday, March 31, 2012
Wednesday, August 10, 2011
AA Is The New AAA.
AA Is The New AAA.
In other words, Standard & Poor’s U.S. Debt downgrade doesn’t change a thing.
America’s loss of its Standard & Poor’s AAA debt rating on Friday will continue to provoke strong reactions, from markets and pundits alike. But nothing has really changed.
Now is not the time to give in to emotions and make rash moves. It's the time to take a few deep breaths and dispassionately set a sensible course for the future.
Let's start with a little perspective. Yes, the fact that U.S. debt no longer carries a top triple-A rating is troubling. But it's not as if S&P told investors something they didn't know before (i.e; that the country's long-term finances are a mess).
As for the economic effect the downgrade might have, that's far from clear. Ultimately, though, bond investors' expectations will be the primary determinant of the yields on Treasury bonds, not the opinion of the ratings agencies.
And, so far, investors seem to be rushing into Treasuries not away from them. So I think people may be overreacting to the whole downgrade thing.
That said, whether the sell-off was an overreaction to the downgrade, the growing sense that the economy may be weaker than previously thought or something else, investors have clearly shown they're extremely nervous about stocks.
But this isn't exactly news either.
Although we lose sight of it from time to time, the fact is that the stock market is and always has been a very volatile place.
The flip side of that volatility, though, is that stocks have also generated some pretty impressive long-term returns. If you look at the 56 rolling 30-year periods from 1926 through 2010 (1926-1955, 1927-1956, etc. through 1981-2010) the lowest annualized return stocks have delivered over a 30-year span is 8.5%, and the average 30-year annualized return for all those periods is 11.3%. For bonds, the numbers are 1.5% and 5.1%, respectively.
This doesn't mean stocks will generate the same gains over the next 30 years. I wouldn't be surprised to see them come in considerably lower.
But I don't see any reason why, over the long term, one would expect stocks to underperform bonds or cash, especially considering the current low yields on bonds and cash equivalents. Remember, just yesterday the U.S. Federal Reserve vowed to keep interest rates at close to zero for the next two years.
So it seems to me that the challenge for someone investing his nest egg today is still pretty much what it was before all the debt-ceiling-downgrade political drama: to participate in stocks' long-term growth without getting hammered too badly when stocks suffer their inevitable periodic declines.
There are two ways you can try to do that. One is to attempt to outguess the market — that is, capitalize on stocks when they're doing well and then move out of them into bonds or cash or gold or whatever to avoid downturns.
The other is to invest in a reasonable mix of stocks and bonds and basically stick to it, allowing the bond portion of your portfolio to dampen stocks' swings. The first approach — moving in, out and around various parts of the market — is difficult-to-impossible to pull off consistently.
If you doubt that, just consider recent events. In the weeks leading up to August 2, investors' biggest fear was that Congress and the Obama administration might fail to raise the debt ceiling on time and thus spark a stock-market meltdown.
People were so convinced that this would threaten their portfolios that many considered moving their money into cash to protect against that possibility. When Congress and the White House reached a deal before the Tuesday deadline, the big market swoon everyone feared was averted.
However, two days later, while investors were still feeling good about dodging the debt-limit bullet, the Dow plummeted 510 points on concerns about the European debt crisis and the possibility of the U.S. sliding back into recession.
And then came Monday's wild 635-point Dow free fall in the wake of S&P's downgrades.
My point is that you can never really tell what might initiate a market decline — let alone know when it might occur.
The more sensible way to participate in stocks' long-term growth is to create a mix of stocks and bonds that gives you the benefit of the balance of probabilities at solid returns and offers at least some protection.
The longer away you are from retirement and the more your stomach can handle the value of your retirement savings taking the occasional decline, the more you can devote to stocks.
The closer you are to retirement and the more upset you get when your nest egg gets scrambled, the more you should tilt toward bonds and cash. If you're on the verge of retirement, that mix might be somewhere around half in stocks and half in bonds.
Taking the asset allocation approach and sticking with it (except for periodic rebalancing) won't immunize you against losses. But it can help you manage the downside risk of stocks without giving up all the upside.
And, more importantly, it gives you a rational way of dealing with the stock market's volatility and keeping downturns to a magnitude you can handle, rather than engaging in a never-ending guessing game.
By trying out different blends and seeing what sort of losses they incurred, you can get a better feel for what stocks-bonds allocation might be right for you.
Remember, though, if you go with too conservative a strategy to guard against market downturns, you limit your upside. So to get a sense of whether the asset allocation you choose will give you a large enough nest egg to support you in retirement, I suggest you use many of the excellent retirement income calculators available for free through many respected financial websites and investment companies.
I don't want to downplay the seriousness of the situation facing investors today. We could very well see lots more turmoil in the financial markets and further declines in stock prices.
But the fact is that there will always be something going on that investors will feel compelled to react to, whether it's the threat of a recession triggering a market meltdown or, in better times, rosy reports of economic growth and corporate profits suggesting the markets will soar.
But if you invest on the basis of hunches and speculation rather than setting a coherent long-term strategy and sticking to it, you'll put yourself at risk of selling after prices have already fallen and buying back in when prices are already inflated.
In the end, that will make it tougher for you to earn the returns you'll need to build a decent nest egg and harder for you to maintain your emotional equilibrium in tumultuous times like these.
In other words, Standard & Poor’s U.S. Debt downgrade doesn’t change a thing.
America’s loss of its Standard & Poor’s AAA debt rating on Friday will continue to provoke strong reactions, from markets and pundits alike. But nothing has really changed.
Now is not the time to give in to emotions and make rash moves. It's the time to take a few deep breaths and dispassionately set a sensible course for the future.
Let's start with a little perspective. Yes, the fact that U.S. debt no longer carries a top triple-A rating is troubling. But it's not as if S&P told investors something they didn't know before (i.e; that the country's long-term finances are a mess).
As for the economic effect the downgrade might have, that's far from clear. Ultimately, though, bond investors' expectations will be the primary determinant of the yields on Treasury bonds, not the opinion of the ratings agencies.
And, so far, investors seem to be rushing into Treasuries not away from them. So I think people may be overreacting to the whole downgrade thing.
That said, whether the sell-off was an overreaction to the downgrade, the growing sense that the economy may be weaker than previously thought or something else, investors have clearly shown they're extremely nervous about stocks.
But this isn't exactly news either.
Although we lose sight of it from time to time, the fact is that the stock market is and always has been a very volatile place.
The flip side of that volatility, though, is that stocks have also generated some pretty impressive long-term returns. If you look at the 56 rolling 30-year periods from 1926 through 2010 (1926-1955, 1927-1956, etc. through 1981-2010) the lowest annualized return stocks have delivered over a 30-year span is 8.5%, and the average 30-year annualized return for all those periods is 11.3%. For bonds, the numbers are 1.5% and 5.1%, respectively.
This doesn't mean stocks will generate the same gains over the next 30 years. I wouldn't be surprised to see them come in considerably lower.
But I don't see any reason why, over the long term, one would expect stocks to underperform bonds or cash, especially considering the current low yields on bonds and cash equivalents. Remember, just yesterday the U.S. Federal Reserve vowed to keep interest rates at close to zero for the next two years.
So it seems to me that the challenge for someone investing his nest egg today is still pretty much what it was before all the debt-ceiling-downgrade political drama: to participate in stocks' long-term growth without getting hammered too badly when stocks suffer their inevitable periodic declines.
There are two ways you can try to do that. One is to attempt to outguess the market — that is, capitalize on stocks when they're doing well and then move out of them into bonds or cash or gold or whatever to avoid downturns.
The other is to invest in a reasonable mix of stocks and bonds and basically stick to it, allowing the bond portion of your portfolio to dampen stocks' swings. The first approach — moving in, out and around various parts of the market — is difficult-to-impossible to pull off consistently.
If you doubt that, just consider recent events. In the weeks leading up to August 2, investors' biggest fear was that Congress and the Obama administration might fail to raise the debt ceiling on time and thus spark a stock-market meltdown.
People were so convinced that this would threaten their portfolios that many considered moving their money into cash to protect against that possibility. When Congress and the White House reached a deal before the Tuesday deadline, the big market swoon everyone feared was averted.
However, two days later, while investors were still feeling good about dodging the debt-limit bullet, the Dow plummeted 510 points on concerns about the European debt crisis and the possibility of the U.S. sliding back into recession.
And then came Monday's wild 635-point Dow free fall in the wake of S&P's downgrades.
My point is that you can never really tell what might initiate a market decline — let alone know when it might occur.
The more sensible way to participate in stocks' long-term growth is to create a mix of stocks and bonds that gives you the benefit of the balance of probabilities at solid returns and offers at least some protection.
The longer away you are from retirement and the more your stomach can handle the value of your retirement savings taking the occasional decline, the more you can devote to stocks.
The closer you are to retirement and the more upset you get when your nest egg gets scrambled, the more you should tilt toward bonds and cash. If you're on the verge of retirement, that mix might be somewhere around half in stocks and half in bonds.
Taking the asset allocation approach and sticking with it (except for periodic rebalancing) won't immunize you against losses. But it can help you manage the downside risk of stocks without giving up all the upside.
And, more importantly, it gives you a rational way of dealing with the stock market's volatility and keeping downturns to a magnitude you can handle, rather than engaging in a never-ending guessing game.
By trying out different blends and seeing what sort of losses they incurred, you can get a better feel for what stocks-bonds allocation might be right for you.
Remember, though, if you go with too conservative a strategy to guard against market downturns, you limit your upside. So to get a sense of whether the asset allocation you choose will give you a large enough nest egg to support you in retirement, I suggest you use many of the excellent retirement income calculators available for free through many respected financial websites and investment companies.
I don't want to downplay the seriousness of the situation facing investors today. We could very well see lots more turmoil in the financial markets and further declines in stock prices.
But the fact is that there will always be something going on that investors will feel compelled to react to, whether it's the threat of a recession triggering a market meltdown or, in better times, rosy reports of economic growth and corporate profits suggesting the markets will soar.
But if you invest on the basis of hunches and speculation rather than setting a coherent long-term strategy and sticking to it, you'll put yourself at risk of selling after prices have already fallen and buying back in when prices are already inflated.
In the end, that will make it tougher for you to earn the returns you'll need to build a decent nest egg and harder for you to maintain your emotional equilibrium in tumultuous times like these.
Tuesday, January 25, 2011
2011 Outlook
“Prediction is very difficult, especially about the future.” -- Niels Bohr
While 2010 was a respectable year, and in a few instances an excellent one, for most financial markets, it came with the sobering realization that many of the global imbalances investors thought were behind us remain, albeit in a slightly altered form. Which leaves the question; will 2011 be the year when these imbalances re-erupt? I believe the answer is no, at least not during the next 12 months.
For 2011, I believe the overall global economic environment is likely to remain conducive for risky assets. I would expect developed markets to stage steady, yet uninspiring recovery. Growth should be subdued but positive, with inflation remaining low. While rates will rise over time, given low inflation and anemic demand for capital from everyone except sovereign borrowers, I believe bond markets will remain stable enough so as not to derail the equity market rally. In emerging markets, I would continue to expect outsized growth, although that growth is likely to slow as emerging market central banks wrestle with inflationary pressures.
For investors, this means considering an overweight to equities and continued exposure to commodities, particularly the more cyclically oriented ones. Within credit, investors should consider overweighting corporate credit versus sovereign credit.
While cyclical factors should support financial markets for another year, to be clear I don’t believe that the market’s bottom in 2009 marked the beginning of a new cyclical bull market. The debt problems that derailed the global economy in 2007 are largely still present; they have simply morphed from the private to the public balance sheet. Government unwillingness to address these issues, particularly in the U.S., leaves both equities and bond markets vulnerable in the long-term to wrenching fiscal austerity, unexpected inflation, or potentially both. Fortunately, that pending crisis looks like it can be postponed for at least another year.
Volatility
A little over three years ago, the Dow Industrials and the TSX hit an all time high and the list of established Wall Street firms still included Lehman Brothers, Bear Stearns, and Merrill Lynch. In the summer of 2008, most financial participants believed the worst of the subprime crisis had been experienced, world equity markets had recovered, and the US Federal Reserve (Fed) was grappling with the highest inflation in decades. A little over a year ago, financial leaders struggled to prevent what seemed like an inevitable slide toward the first global depression in 80 years.
Three years, three different market environments that experts were mistakenly confident would continue. Extrapolating from the past is a dangerous exercise during even the best and most stable of times. During periods of volatility, it is simple folly. Today, it is no illusion that the world has become more volatile. Consider the following: 10-year trailing U.S. inflation volatility is at a 50+ year high, over the past two years dollar volatility is the highest on record, and gold prices are the most volatile they have been since the mid-1980’s.
Nor is the recent volatility limited to financial markets. The volatility in asset prices has coincided with – orguably been caused by – a similar spike in political instability. The U.S. Congress has changed hands --- Republican to Democrat and back again – twice in a six-year period. This has not happened since the 1950s. At the same time, the U.S. Federal Reserve has tripled the size of its balance sheet over the past thirty months, and plans to continue this exercise through at least the middle of 2011. Outside the United States, the tenure of Japanese prime ministers is starting to resemble that of Italian ones, and an indecisive election in the United Kingdom has produced the first coalition government since the Second World War. Canada and Ireland have minority governments. Politically, economically, and financially we are living in an age of renewed volatility.
The one unqualified prediction that I will make for 2011 is that economic and political volatility will continue. There are three reasons to believe this.
First, many of the global imbalances which precipitated the previous crisis are still around, albeit in slightly altered forms. Instead of a pending subprime meltdown, we have the growing risk of sovereign debt, which will be further exacerbated by aging populations and unsustainable entitlement spending in much of the developed world.
Second, the aftermath of financial bubbles is characterized by slow, anemic recoveries in both economic growth and housing. Both of these will contribute to overall economic and political volatility.
Finally, the ongoing economic shift from developing to emerging markets will be a slow process, one that is likely to play out over decades. As it does, there are likely to be accompanying growing pains.
The good news for investors in the near term is that many of the longer-term imbalances still facing the global economy are unlikely to erupt over the next 12 months. So my baseline view for 2011 is a temporary lull followed by a lackluster but steady recovery in the developed markets with continued low inflation. In the emerging markets, we would expect continued strong economic growth. All things considered, not a bad environment for global equity markets.
Bonds are likely to hold up, at least through the first half of the year, but given valuations and supply issues they don’t appear to offer the best value.
It is important to note that the relatively sanguine outlook for next year does not imply that the global economy has put its troubles behind it. On the contrary, many of the structural imbalances that pushed us into the global crisis are still with us, albeit in an altered form. Ironically, many of the policies that are likely to promote a decent year for economies and markets, i.e. extension of the Bush tax cuts and maintaining transfer payments to individuals (employment benefits in the U.S.), will exacerbate the longer-term imbalances. At some point, the strain is likely to begin to show even on the largest and richest nations, but that is probably not an issue for 2011.
While 2010 was a respectable year, and in a few instances an excellent one, for most financial markets, it came with the sobering realization that many of the global imbalances investors thought were behind us remain, albeit in a slightly altered form. Which leaves the question; will 2011 be the year when these imbalances re-erupt? I believe the answer is no, at least not during the next 12 months.
For 2011, I believe the overall global economic environment is likely to remain conducive for risky assets. I would expect developed markets to stage steady, yet uninspiring recovery. Growth should be subdued but positive, with inflation remaining low. While rates will rise over time, given low inflation and anemic demand for capital from everyone except sovereign borrowers, I believe bond markets will remain stable enough so as not to derail the equity market rally. In emerging markets, I would continue to expect outsized growth, although that growth is likely to slow as emerging market central banks wrestle with inflationary pressures.
For investors, this means considering an overweight to equities and continued exposure to commodities, particularly the more cyclically oriented ones. Within credit, investors should consider overweighting corporate credit versus sovereign credit.
While cyclical factors should support financial markets for another year, to be clear I don’t believe that the market’s bottom in 2009 marked the beginning of a new cyclical bull market. The debt problems that derailed the global economy in 2007 are largely still present; they have simply morphed from the private to the public balance sheet. Government unwillingness to address these issues, particularly in the U.S., leaves both equities and bond markets vulnerable in the long-term to wrenching fiscal austerity, unexpected inflation, or potentially both. Fortunately, that pending crisis looks like it can be postponed for at least another year.
Volatility
A little over three years ago, the Dow Industrials and the TSX hit an all time high and the list of established Wall Street firms still included Lehman Brothers, Bear Stearns, and Merrill Lynch. In the summer of 2008, most financial participants believed the worst of the subprime crisis had been experienced, world equity markets had recovered, and the US Federal Reserve (Fed) was grappling with the highest inflation in decades. A little over a year ago, financial leaders struggled to prevent what seemed like an inevitable slide toward the first global depression in 80 years.
Three years, three different market environments that experts were mistakenly confident would continue. Extrapolating from the past is a dangerous exercise during even the best and most stable of times. During periods of volatility, it is simple folly. Today, it is no illusion that the world has become more volatile. Consider the following: 10-year trailing U.S. inflation volatility is at a 50+ year high, over the past two years dollar volatility is the highest on record, and gold prices are the most volatile they have been since the mid-1980’s.
Nor is the recent volatility limited to financial markets. The volatility in asset prices has coincided with – orguably been caused by – a similar spike in political instability. The U.S. Congress has changed hands --- Republican to Democrat and back again – twice in a six-year period. This has not happened since the 1950s. At the same time, the U.S. Federal Reserve has tripled the size of its balance sheet over the past thirty months, and plans to continue this exercise through at least the middle of 2011. Outside the United States, the tenure of Japanese prime ministers is starting to resemble that of Italian ones, and an indecisive election in the United Kingdom has produced the first coalition government since the Second World War. Canada and Ireland have minority governments. Politically, economically, and financially we are living in an age of renewed volatility.
The one unqualified prediction that I will make for 2011 is that economic and political volatility will continue. There are three reasons to believe this.
First, many of the global imbalances which precipitated the previous crisis are still around, albeit in slightly altered forms. Instead of a pending subprime meltdown, we have the growing risk of sovereign debt, which will be further exacerbated by aging populations and unsustainable entitlement spending in much of the developed world.
Second, the aftermath of financial bubbles is characterized by slow, anemic recoveries in both economic growth and housing. Both of these will contribute to overall economic and political volatility.
Finally, the ongoing economic shift from developing to emerging markets will be a slow process, one that is likely to play out over decades. As it does, there are likely to be accompanying growing pains.
The good news for investors in the near term is that many of the longer-term imbalances still facing the global economy are unlikely to erupt over the next 12 months. So my baseline view for 2011 is a temporary lull followed by a lackluster but steady recovery in the developed markets with continued low inflation. In the emerging markets, we would expect continued strong economic growth. All things considered, not a bad environment for global equity markets.
Bonds are likely to hold up, at least through the first half of the year, but given valuations and supply issues they don’t appear to offer the best value.
It is important to note that the relatively sanguine outlook for next year does not imply that the global economy has put its troubles behind it. On the contrary, many of the structural imbalances that pushed us into the global crisis are still with us, albeit in an altered form. Ironically, many of the policies that are likely to promote a decent year for economies and markets, i.e. extension of the Bush tax cuts and maintaining transfer payments to individuals (employment benefits in the U.S.), will exacerbate the longer-term imbalances. At some point, the strain is likely to begin to show even on the largest and richest nations, but that is probably not an issue for 2011.
Friday, July 23, 2010
Demographics, Growth and Investments.
The Alternative To Growth Is Decline. Europe Is Proof.
A shrinking population and inflated expectations are a damaging mix.
Growth, whether it is economic growth or population growth, has almost become a swearword in the modern lexicon. It now needs to be qualified by the adjective "sustainable", or no one will subscribe to it.
Whenever a phrase is so self-evidently correct that no right-minded person would call for the opposite, it is usually a good indication that it is meaningless.
This is true for "sustainable growth", because no one would call for unsustainable growth. It is also true for "moving forward", as only some crustaceans prefer going backwards, and for "real action", because few voters would opt for "fake action" instead.
Apart from these semantic peculiarities, it is remarkable that the idea of limiting growth is striking a chord with voters in many Western countries, or at least with focus groups in those countries. Canadians seem quick to judge our American cousins with their seeming preoccupation with growth (at any cost). Will this hubris cost us down the road?
After one of the longest periods of growth in Canada's recent history, it seems that many Canadians have obviously forgotten that there is only one thing that's more unpleasant than dealing with the side-effects of growth. It's dealing with the side-effects of decline. In order to remind ourselves about this, we should look at Europe.
The financial crisis has hit Europe hard. It mercilessly exposed the weaknesses of Europe's social and economic model. Over the past decades, Europe had developed into a place in which governments took on an ever-increasing role, consuming more and more of the national economic output.
Taxes were no longer sufficient to satisfy politicians' appetite for more generous spending commitments, so deficits had to fill the gap between tax revenues and political ambitions.
At the same time, Europeans ceased to reproduce. In industrialised nations, the birthrate needs to be 2.1 children per woman in order to keep the native population stable. In many European countries, however, it has been far below this figure.
In the worst year so far, Italy recorded a fertility rate of 1.19. It has since recovered a bit, but with birthrates in the region between 1.3 and 1.4 in countries such as Germany, Italy or Spain, it is still far from the level at which these countries would remain stable.
A shrinking population would be a challenge in itself, but in Europe's case the problems are multiplied by rapidly improving life expectancy. Although arguably today's older generations are far healthier and generally more active than previous generations, it is nevertheless true that older populations mean relatively fewer taxpayers, more pensioners and more people in need of health care.
The mix of high-spending governments, increased life expectancy and lower fertility had for a long time produced a Europe that was a rather pleasant place to live.
However, it was not economically sustainable. After the shock of the financial crisis, Europeans are slowly waking up to the fact that they have created a continent that is on the verge of shrinking, with regard to its economic significance and its overall population.
As a whole, Europe will lose more than 60 million people over the next five decades. The remaining population will be much older than any other population in world history. In terms of demography, Europe is entering uncharted territory. What it will mean to live in country where there are as many people over the age of 80 as there are people under the age of 20 is hard to imagine, but many Europeans countries will soon find out.
The challenges of this demographic change are going to be enormous. Fewer taxpayers will have to shoulder an unprecedented increase in healthcare facilities. Qualified labour will be in short supply as working-age populations are already shrinking across Europe. This in turn will push up wages and prices; inflationary pressures are increasing.
Meanwhile, it will become more difficult to service the existing debt burdens.
The European example is a clear indication of what happens if a society enters into the no-growth zone. It sucks the energy out of the economy, and politicians are condemned to managing the decline with little room for manoeuvre.
When comparing Canada's growth chances to the European predicament of shrinking and decline, it should not be hard to decide which path is more tempting.
Growth is not everything, but without growth everything is more difficult.
Until investors realise this, they won’t be offered "truly forward-moving real action" on investment choices.
A shrinking population and inflated expectations are a damaging mix.
Growth, whether it is economic growth or population growth, has almost become a swearword in the modern lexicon. It now needs to be qualified by the adjective "sustainable", or no one will subscribe to it.
Whenever a phrase is so self-evidently correct that no right-minded person would call for the opposite, it is usually a good indication that it is meaningless.
This is true for "sustainable growth", because no one would call for unsustainable growth. It is also true for "moving forward", as only some crustaceans prefer going backwards, and for "real action", because few voters would opt for "fake action" instead.
Apart from these semantic peculiarities, it is remarkable that the idea of limiting growth is striking a chord with voters in many Western countries, or at least with focus groups in those countries. Canadians seem quick to judge our American cousins with their seeming preoccupation with growth (at any cost). Will this hubris cost us down the road?
After one of the longest periods of growth in Canada's recent history, it seems that many Canadians have obviously forgotten that there is only one thing that's more unpleasant than dealing with the side-effects of growth. It's dealing with the side-effects of decline. In order to remind ourselves about this, we should look at Europe.
The financial crisis has hit Europe hard. It mercilessly exposed the weaknesses of Europe's social and economic model. Over the past decades, Europe had developed into a place in which governments took on an ever-increasing role, consuming more and more of the national economic output.
Taxes were no longer sufficient to satisfy politicians' appetite for more generous spending commitments, so deficits had to fill the gap between tax revenues and political ambitions.
At the same time, Europeans ceased to reproduce. In industrialised nations, the birthrate needs to be 2.1 children per woman in order to keep the native population stable. In many European countries, however, it has been far below this figure.
In the worst year so far, Italy recorded a fertility rate of 1.19. It has since recovered a bit, but with birthrates in the region between 1.3 and 1.4 in countries such as Germany, Italy or Spain, it is still far from the level at which these countries would remain stable.
A shrinking population would be a challenge in itself, but in Europe's case the problems are multiplied by rapidly improving life expectancy. Although arguably today's older generations are far healthier and generally more active than previous generations, it is nevertheless true that older populations mean relatively fewer taxpayers, more pensioners and more people in need of health care.
The mix of high-spending governments, increased life expectancy and lower fertility had for a long time produced a Europe that was a rather pleasant place to live.
However, it was not economically sustainable. After the shock of the financial crisis, Europeans are slowly waking up to the fact that they have created a continent that is on the verge of shrinking, with regard to its economic significance and its overall population.
As a whole, Europe will lose more than 60 million people over the next five decades. The remaining population will be much older than any other population in world history. In terms of demography, Europe is entering uncharted territory. What it will mean to live in country where there are as many people over the age of 80 as there are people under the age of 20 is hard to imagine, but many Europeans countries will soon find out.
The challenges of this demographic change are going to be enormous. Fewer taxpayers will have to shoulder an unprecedented increase in healthcare facilities. Qualified labour will be in short supply as working-age populations are already shrinking across Europe. This in turn will push up wages and prices; inflationary pressures are increasing.
Meanwhile, it will become more difficult to service the existing debt burdens.
The European example is a clear indication of what happens if a society enters into the no-growth zone. It sucks the energy out of the economy, and politicians are condemned to managing the decline with little room for manoeuvre.
When comparing Canada's growth chances to the European predicament of shrinking and decline, it should not be hard to decide which path is more tempting.
Growth is not everything, but without growth everything is more difficult.
Until investors realise this, they won’t be offered "truly forward-moving real action" on investment choices.
Thursday, December 3, 2009
Year End Review
Looking Back - and Looking Forward
2009 was one of those years that reminded us what a roller coaster the stock market can be – and also of the dangers of conventional thinking.
After the collapse in global financial markets last fall and the resulting pummeling taken by stock markets around the world, the consensus in January was that the worst was behind us. That was a sharp reminder of the danger of conventional thinking – by early March, markets in Canada had declined by a further 15% and the U.S. was down by 25%.
At that point, the consensus shifted and there was growing sentiment that we might be entering a long period of economic stagnation; that’s when we heard respected economic forecasters talk about a one in five chance of another depression. It was precisely at this point that the coordinated stimulus spending by governments around the world finally had an impact and we began seeing signs of an economic recovery. From the market’s bottom on March 9 to the end of November, global markets were up by 50% to 65%.
Thus, 2009 was a sharp reminder that it’s impossible to predict short term market movements.
Instead we need to focus on two key questions:
1. First, what do the prospects for economic and profit growth look like in the mid term – 12 to 18 months and beyond?
2. Second, to what extent are these prospects for growth accurately reflected in today’s prices of stocks and bonds?
Mid-Term Prospects For Growth
In building portfolios, we have to start with some core assumptions about the environment we’ll be in going forward.
Noted British historian Paul Johnson has written that at every given point in time, you can always point to good news and bad news – the only difference is the balance between the two and what the media pays attention to.
In early 2000 (at the height of the tech bubble) and the beginning of 2008 (at the top of the real estate and finance bubble), all we read about was good news – almost no attention was paid to any offsetting concerns. By contrast, during market bottoms at the end of 2003 and early 2009, all we saw was the bad news – it’s as if there were no positives on the horizon.
Despite the recovery in the global economy and markets since the early part of this year, the general sentiment and confidence level among many people today is quite negative. Much of that is driven by concerns about the U.S. economy – still the engine of global growth.
And certainly there are lots of things to worry about in the U.S. – stubbornly high unemployment, a housing market that is still depressed (although no longer in decline) and Government deficits.
Without dismissing the short term challenges facing the US, it’s important not to lose sight of some important underlying positives.
In an August cover story on “The case for optimism” Business Week Magazine highlighted a number of reasons to be positive, among them the impact of technology and free markets in emerging economies.
Click here to read more about what Business Week had to say:
http://www.businessweek.com/magazine/toc/09_34/B4144optimism.htm?chan=magazine+channel_top+stories
And recently two respected columnists at the New York Times, Thomas Friedman and David Brooks, weighed in on both the positives in the U.S. and some of the challenges that America faces.
http://www.nytimes.com/2009/11/22/opinion/22friedman.html
http://www.nytimes.com/2009/11/17/opinion/17brooks.html
The bottom line is: In the mid term I believe the positives outweigh the negatives and that the dire predictions about America’s decline are overstated. It may not see the rapid growth we’ve seen in the past but it will see solid growth.
Today’s Valuation Levels
Being right on our midterm outlook for the economy only helps us if we buy stocks and bonds at attractive prices.
With regard to bonds, at current interest rates of about 3% it is hard to make a case for Government bonds as anything except a safe harbour against more market disruption.
The returns on corporate bonds are more interesting – especially toward the bottom of the investment grade category, which currently yield about 6%. Note that we do have to be very selective here, since companies with low investment grade ratings are susceptible to shocks and downgrades should the economy run into difficulty.
On the issue of valuation levels of stocks, there are lots of academics who have made a career of studying markets. Of these, I follow two in particular – Jeremy Siegel at the Wharton School at the University of Pennsylvania and Robert Shiller at Yale. Between them, they forecast both the technology and the U.S. real estate bubbles.
Robert Shiller believes stocks should be valued based on their average earnings over the past ten years, using what he calls the Cyclically Adujsted Price Earnings ratio (CAPE for short). Employing that measure, at the end of November Shiller calculates the U.S. market’s multiple is 19.5 x times average earnings for the past ten years, within the normal historical range (although at the high end of that range.)
Prior to 2008, you have to go back to 1992 to find the last time we saw this multiple consistently below twenty times average ten year earnings. Throughout the period from 1997 to 2001, this multiple was in the thirties and forties – when the multiple was in its forties, you were paying twice as much for a dollar of earnings as you are today.
Jeremy Siegel is the best known researcher on long term returns in the stock market and author of Stocks for the Long Run, often cited as one of the all-time ten most influential books on investing. Among his claims to fame is an article in the Wall Street Journal at the peak of the tech mania in early 2000, predicting that sector’s collapse.
In September, Siegel did two interviews on long term returns and current valuations, in which he talked about his research and his opinion that stocks offered good value at the time. You can see those interviews below:
Professor Jeremy Siegel on today’s market outlook:
http://www.clientinsights.ca/video/today-s-valuation-levels-and-market-outlook/type:investor
Professor Jeremy Siegel on long term stock returns:
http://www.clientinsights.ca/video/stocks-for-the-long-run-and-long-term-returns/type:investor
The bottom line from these two experts: While stocks are not as cheap as they were in March, by historical standards they do offer reasonable value.
While we can expect continued volatility in 2010, we do believe that returns on stocks in the period ahead will be in line with historical levels.
The Right Approach For Your Portfolio
While my team and I spend a great deal of time focusing on the big picture, the most important issue is how we adapt that view to each client’s individual portfolio.
For older clients, we have always been believers in maintaining conservative, balanced portfolios – that stance protected our retired clients from the worst of the decline in 2008 and early this year. Today, we are focusing on higher quality stocks, as we believe that these will provide the best risk return trade-off going forward.
In summary, we are cautiously optimistic about the American, Canadian and the global economy’s ability to work through some of the current issues they face – and believe that valuations on stocks will make quality stocks an attractive investment in the mid-term.
We look forward to continuing to work with you in 2010 to ensure you have the portfolio that is right for you – and thank you again for the opportunity to work with you over the past while.
As always, my team and I area always available to talk about any questions that you might have.
In the meantime, best wishes for a relaxing holiday season – I look forward to talking in 2010.
2009 was one of those years that reminded us what a roller coaster the stock market can be – and also of the dangers of conventional thinking.
After the collapse in global financial markets last fall and the resulting pummeling taken by stock markets around the world, the consensus in January was that the worst was behind us. That was a sharp reminder of the danger of conventional thinking – by early March, markets in Canada had declined by a further 15% and the U.S. was down by 25%.
At that point, the consensus shifted and there was growing sentiment that we might be entering a long period of economic stagnation; that’s when we heard respected economic forecasters talk about a one in five chance of another depression. It was precisely at this point that the coordinated stimulus spending by governments around the world finally had an impact and we began seeing signs of an economic recovery. From the market’s bottom on March 9 to the end of November, global markets were up by 50% to 65%.
Thus, 2009 was a sharp reminder that it’s impossible to predict short term market movements.
Instead we need to focus on two key questions:
1. First, what do the prospects for economic and profit growth look like in the mid term – 12 to 18 months and beyond?
2. Second, to what extent are these prospects for growth accurately reflected in today’s prices of stocks and bonds?
Mid-Term Prospects For Growth
In building portfolios, we have to start with some core assumptions about the environment we’ll be in going forward.
Noted British historian Paul Johnson has written that at every given point in time, you can always point to good news and bad news – the only difference is the balance between the two and what the media pays attention to.
In early 2000 (at the height of the tech bubble) and the beginning of 2008 (at the top of the real estate and finance bubble), all we read about was good news – almost no attention was paid to any offsetting concerns. By contrast, during market bottoms at the end of 2003 and early 2009, all we saw was the bad news – it’s as if there were no positives on the horizon.
Despite the recovery in the global economy and markets since the early part of this year, the general sentiment and confidence level among many people today is quite negative. Much of that is driven by concerns about the U.S. economy – still the engine of global growth.
And certainly there are lots of things to worry about in the U.S. – stubbornly high unemployment, a housing market that is still depressed (although no longer in decline) and Government deficits.
Without dismissing the short term challenges facing the US, it’s important not to lose sight of some important underlying positives.
In an August cover story on “The case for optimism” Business Week Magazine highlighted a number of reasons to be positive, among them the impact of technology and free markets in emerging economies.
Click here to read more about what Business Week had to say:
http://www.businessweek.com/magazine/toc/09_34/B4144optimism.htm?chan=magazine+channel_top+stories
And recently two respected columnists at the New York Times, Thomas Friedman and David Brooks, weighed in on both the positives in the U.S. and some of the challenges that America faces.
http://www.nytimes.com/2009/11/22/opinion/22friedman.html
http://www.nytimes.com/2009/11/17/opinion/17brooks.html
The bottom line is: In the mid term I believe the positives outweigh the negatives and that the dire predictions about America’s decline are overstated. It may not see the rapid growth we’ve seen in the past but it will see solid growth.
Today’s Valuation Levels
Being right on our midterm outlook for the economy only helps us if we buy stocks and bonds at attractive prices.
With regard to bonds, at current interest rates of about 3% it is hard to make a case for Government bonds as anything except a safe harbour against more market disruption.
The returns on corporate bonds are more interesting – especially toward the bottom of the investment grade category, which currently yield about 6%. Note that we do have to be very selective here, since companies with low investment grade ratings are susceptible to shocks and downgrades should the economy run into difficulty.
On the issue of valuation levels of stocks, there are lots of academics who have made a career of studying markets. Of these, I follow two in particular – Jeremy Siegel at the Wharton School at the University of Pennsylvania and Robert Shiller at Yale. Between them, they forecast both the technology and the U.S. real estate bubbles.
Robert Shiller believes stocks should be valued based on their average earnings over the past ten years, using what he calls the Cyclically Adujsted Price Earnings ratio (CAPE for short). Employing that measure, at the end of November Shiller calculates the U.S. market’s multiple is 19.5 x times average earnings for the past ten years, within the normal historical range (although at the high end of that range.)
Prior to 2008, you have to go back to 1992 to find the last time we saw this multiple consistently below twenty times average ten year earnings. Throughout the period from 1997 to 2001, this multiple was in the thirties and forties – when the multiple was in its forties, you were paying twice as much for a dollar of earnings as you are today.
Jeremy Siegel is the best known researcher on long term returns in the stock market and author of Stocks for the Long Run, often cited as one of the all-time ten most influential books on investing. Among his claims to fame is an article in the Wall Street Journal at the peak of the tech mania in early 2000, predicting that sector’s collapse.
In September, Siegel did two interviews on long term returns and current valuations, in which he talked about his research and his opinion that stocks offered good value at the time. You can see those interviews below:
Professor Jeremy Siegel on today’s market outlook:
http://www.clientinsights.ca/video/today-s-valuation-levels-and-market-outlook/type:investor
Professor Jeremy Siegel on long term stock returns:
http://www.clientinsights.ca/video/stocks-for-the-long-run-and-long-term-returns/type:investor
The bottom line from these two experts: While stocks are not as cheap as they were in March, by historical standards they do offer reasonable value.
While we can expect continued volatility in 2010, we do believe that returns on stocks in the period ahead will be in line with historical levels.
The Right Approach For Your Portfolio
While my team and I spend a great deal of time focusing on the big picture, the most important issue is how we adapt that view to each client’s individual portfolio.
For older clients, we have always been believers in maintaining conservative, balanced portfolios – that stance protected our retired clients from the worst of the decline in 2008 and early this year. Today, we are focusing on higher quality stocks, as we believe that these will provide the best risk return trade-off going forward.
In summary, we are cautiously optimistic about the American, Canadian and the global economy’s ability to work through some of the current issues they face – and believe that valuations on stocks will make quality stocks an attractive investment in the mid-term.
We look forward to continuing to work with you in 2010 to ensure you have the portfolio that is right for you – and thank you again for the opportunity to work with you over the past while.
As always, my team and I area always available to talk about any questions that you might have.
In the meantime, best wishes for a relaxing holiday season – I look forward to talking in 2010.
Wednesday, September 16, 2009
Quarterly Review - Cautiously Optimistic
As I write this new post, it’s two weeks from the end of the third quarter in what continues to be a most eventful year for stock markets and the economy.
It’s also one year since the weekend that shook the foundations of Wall Street and of the global financial system – when Lehman Brothers collapsed, Merrill Lynch vanished as an independent entity and AIG was taken over by the U.S. government.
In light of that, I thought it might be worthwhile to briefly summarize where we’ve been this year, where we are today and the prospects for the period ahead – and also to highlight some lessons from last year’s financial collapse.
Where we’ve been
Six months ago, in early March, it truly did feel like the world might be coming to an end – talk of a return to a Great Depression like economy dominated radio, television and newspaper. Understandably, fear was rampant – and stocks responded to these nightmarish scenarios by hitting the lowest levels in years, with financials especially hard hit.
Although no one knew it at the time, that turned out to be the bottom. Since then, we’ve seen the economy move back from the precipice – there is a growing consensus that we’ll return to economic growth in the second half of this year. The Economist magazine recently ran a cover story discussing the extent to which the economic recovery was led by Asia.
As a result, we’ve had a strong recovery in markets – from their bottom in the beginning of March, stock markets are up 50%, retracing a good portion of the losses since last fall.
The second quarter of this year, from March to June, was especially strong – since 1956 the Canadian market has only had three quarters that rose more than this one.
In the meantime, here are six lessons from the last twelve months:
1. We were reminded of just how volatile stocks can be.
2. And of the importance of true diversification.
3. Many investors discovered that they’re less comfortable with risk and volatility in their portfolio than they had believed.
4. Investors were also reminded of the need to focus on what they can control – understanding cash needs and thinking through how much risk they can live with to fund those needs.
5. In some cases, investors began rethinking retirement plans as a result.
6. Finally, we were reminded that in today’s world, we need to expect the unexpected.
Where we are today
A year ago, the market was characterized by rampant optimism. The Canadian market had hit a new high in June of 2008 and any concerns were set aside as minor annoyances.
By contrast, six months ago the market was overwhelmed by absolute pessimism – there was no sign of hope anywhere.
Today, the market is somewhere between those two extremes and many investors can be characterized as extremely nervous.
As a general rule, I think a certain level of healthy anxiety is positive – what gets investors in trouble is an excess of either optimism or pessimism. While today’s mood may be erring on the side of being a bit too pessimistic, I think being cautious in the current market makes sense … provided that prudent caution doesn’t cross the line into panicked inertia.
The good news is that there are still excellent opportunities for investors who are prepared for short term volatility. I spend a lot of time listening to the best market minds and to managers who have lived through multiple cycles. I am reassured that most say that they are still finding very good value – not to the extent that they did earlier this year, but still well ahead of what they would have seen a year ago.
The outlook going forward
In August, Business Week ran a cover story called “The case for optimism.”
The premise was simple: Beyond the issues facing the global economy, there are many underlying positives that give cause for optimism if we look out two and three years and beyond.
There are things happening under the surface that will drive economic growth … and with that economic growth will come growth in stock prices. Examples include the positive impact of technology, the recovering US housing market, the revitalization of economies and the incredible energy from the developing world’s educated youth and emerging middle class.
Click here to access all the Business Week stories on The Case for OPTIMISM :
http://www.businessweek.com/magazine/toc/09_34/B4144optimism.htm?chan=magazine+channel_top+stories
And here to view a three minute video with interviews with CEOs of Dow Corning, Eastman Kodak and Intuit.
http://feedroom.businessweek.com/?fr_story=34b1f5ab213d48a160a767c9c6c50d091f6cc7a3
Volatility
Let me close by talking about market volatility.
In 1907, U.S. financier J. Pierpoint Morgan almost singlehandedly averted a banking panic among U.S. investors by pledging large sums of his own money, and convinced other New York bankers to do the same, to shore up the banking system. At the time, the United States did not have a central bank to inject liquidity back into the market.
Later in life, someone asked him his best guess on the direction of markets. His answer: “They will go up and they will go down.”
One hundred years later, that’s still the best answer to someone looking for a short term market forecast. No one can predict market movements in the immediate period ahead – all we can do is understand clearly how much short term volatility we can live with, adjust our portfolios accordingly and stay focused on the horizon as we deal with the rough waters. No one likes volatility … but for most of us it’s the necessary price to arrive at our ultimate destination.
It’s also one year since the weekend that shook the foundations of Wall Street and of the global financial system – when Lehman Brothers collapsed, Merrill Lynch vanished as an independent entity and AIG was taken over by the U.S. government.
In light of that, I thought it might be worthwhile to briefly summarize where we’ve been this year, where we are today and the prospects for the period ahead – and also to highlight some lessons from last year’s financial collapse.
Where we’ve been
Six months ago, in early March, it truly did feel like the world might be coming to an end – talk of a return to a Great Depression like economy dominated radio, television and newspaper. Understandably, fear was rampant – and stocks responded to these nightmarish scenarios by hitting the lowest levels in years, with financials especially hard hit.
Although no one knew it at the time, that turned out to be the bottom. Since then, we’ve seen the economy move back from the precipice – there is a growing consensus that we’ll return to economic growth in the second half of this year. The Economist magazine recently ran a cover story discussing the extent to which the economic recovery was led by Asia.
As a result, we’ve had a strong recovery in markets – from their bottom in the beginning of March, stock markets are up 50%, retracing a good portion of the losses since last fall.
The second quarter of this year, from March to June, was especially strong – since 1956 the Canadian market has only had three quarters that rose more than this one.
In the meantime, here are six lessons from the last twelve months:
1. We were reminded of just how volatile stocks can be.
2. And of the importance of true diversification.
3. Many investors discovered that they’re less comfortable with risk and volatility in their portfolio than they had believed.
4. Investors were also reminded of the need to focus on what they can control – understanding cash needs and thinking through how much risk they can live with to fund those needs.
5. In some cases, investors began rethinking retirement plans as a result.
6. Finally, we were reminded that in today’s world, we need to expect the unexpected.
Where we are today
A year ago, the market was characterized by rampant optimism. The Canadian market had hit a new high in June of 2008 and any concerns were set aside as minor annoyances.
By contrast, six months ago the market was overwhelmed by absolute pessimism – there was no sign of hope anywhere.
Today, the market is somewhere between those two extremes and many investors can be characterized as extremely nervous.
As a general rule, I think a certain level of healthy anxiety is positive – what gets investors in trouble is an excess of either optimism or pessimism. While today’s mood may be erring on the side of being a bit too pessimistic, I think being cautious in the current market makes sense … provided that prudent caution doesn’t cross the line into panicked inertia.
The good news is that there are still excellent opportunities for investors who are prepared for short term volatility. I spend a lot of time listening to the best market minds and to managers who have lived through multiple cycles. I am reassured that most say that they are still finding very good value – not to the extent that they did earlier this year, but still well ahead of what they would have seen a year ago.
The outlook going forward
In August, Business Week ran a cover story called “The case for optimism.”
The premise was simple: Beyond the issues facing the global economy, there are many underlying positives that give cause for optimism if we look out two and three years and beyond.
There are things happening under the surface that will drive economic growth … and with that economic growth will come growth in stock prices. Examples include the positive impact of technology, the recovering US housing market, the revitalization of economies and the incredible energy from the developing world’s educated youth and emerging middle class.
Click here to access all the Business Week stories on The Case for OPTIMISM :
http://www.businessweek.com/magazine/toc/09_34/B4144optimism.htm?chan=magazine+channel_top+stories
And here to view a three minute video with interviews with CEOs of Dow Corning, Eastman Kodak and Intuit.
http://feedroom.businessweek.com/?fr_story=34b1f5ab213d48a160a767c9c6c50d091f6cc7a3
Volatility
Let me close by talking about market volatility.
In 1907, U.S. financier J. Pierpoint Morgan almost singlehandedly averted a banking panic among U.S. investors by pledging large sums of his own money, and convinced other New York bankers to do the same, to shore up the banking system. At the time, the United States did not have a central bank to inject liquidity back into the market.
Later in life, someone asked him his best guess on the direction of markets. His answer: “They will go up and they will go down.”
One hundred years later, that’s still the best answer to someone looking for a short term market forecast. No one can predict market movements in the immediate period ahead – all we can do is understand clearly how much short term volatility we can live with, adjust our portfolios accordingly and stay focused on the horizon as we deal with the rough waters. No one likes volatility … but for most of us it’s the necessary price to arrive at our ultimate destination.
Wednesday, July 15, 2009
An Unconventional Approach for Unconventional Times
An Unconventional Approach for Unconventional Times
In other words, everything you know about asset allocation is wrong.
Strong words indeed.
The unprecedented seems to happen all too frequently in financial markets. Is there something wrong with the way financial advisors build their clients' portfolios?
Modern Portfolio Theory (MPT) has been the very bedrock of investment management and, more specifically, portfolio construction and asset allocation, for decades. To oversimplify, one might explain MPT in this way: It is literally a mathematical proof for the idea that you shouldn't put all of your investment eggs in one basket. According to MPT, a portfolio of non-correlated assets — distributed across the risk spectrum — can lower the overall risk of a portfolio.
Of course, MPT has been picked apart by legions of critics over the years. But suddenly, in the aftermath of the recent stock market debacle — in which nothing seemed to work at all — critics of MPT are gaining currency.
The very foundation of modern asset allocation just doesn't work, they say.
Enter “Post Modern” Portfolio Theory (PMPT).
The debate between believers in the two different approaches to portfolio construction centers around how they define risk, and how that risk influences returns. MPT models risk using standard deviation above and below expected returns (also called mean variance). PMPT models risk using only standard deviation below expected returns (semivariance). In other words, MPT assumes that there is such a thing as upside “risk,” whereas PMPT proponents believe that only downside risk matters to investors.
This difference seems to give PMPT modeling greater power to predict disasters. In fact, applying MPT's concept of standard deviation to the monthly returns of the S&P 500 indicates a monthly loss greater than 12.8 percent has nearly no chance of happening. But it has occurred 12 times since 1926.
PMPT, say supporters, allows for last year's upset because it measures asymmetrical return distributions.
It’s a Post Modern World.
When the world was presented with Mean Variance Analysis [the basis of MPT] for looking at risk/return, it was the first of its kind back in 1952. No one had seen nor done anything like that before.
However, problem with the mean variance approach and what is known as the Capital Asset Pricing Model was that it assumed that every investor has the same objective. And that's just not true.
What is risk? To many, it is essentially the fact that we don't know what's going to happen, good or bad.
In short, predicting the future is impossible — though both MPT and PMPT still try to do this with modeling.
A major difference is that MPT assumes all investors have the same investment objective: to maximize the expected return for a given level of risk as measured by deviations around the mean. And so, for example, many retirement calculators suggest that 40 year olds who claim to have moderate risk tolerance plunk 40 percent of their assets in fixed income — which assumes these individuals, whether janitor or executive, will have exactly the same goals.
Subscribers to PMPT say, conversely, that investors have different and often very specific goals. The focal point should not be the maximum return possible given a certain level of risk, but rather the rate of return that must be earned in order to accomplish these specific investment goals, such as retirement or paying for college tuition, with minimum risk.
The risk, then, is defined as the possibility that the investor will be unable to accomplish the goal. As a result, returns below the target rate of return (“downside risk”) incur risk; returns above the target do not. With client portfolios suffering some of the largest losses in a generation, wouldn't everyone want a better handle on downside risk?
Don’t get me wrong. I do not have the audacity (nor the post graduate degrees) to suggest that MPT is wrong. The trouble I have is in the input variables. We've been using long-term averages for inputs. Historic averages have no predictive power at all. We’re told that by the very same people who expound on the virtues of MPT.
Indeed the concept of average expected returns, a central assumption in MPT, has taken a huge whack in the wake of the worst bear market in years, a bear so savage that it wiped out 12 years of equity returns in 16 months. Until now, who would have imagined the following could be true: Between 1969 and 2009, investing in 20-year Treasury bonds yielded better returns than investing in the S&P 500, according to research provided by Standard and Poor.
So much for the idea that over the long term, greater risk means greater reward.
Just food for thought.
In other words, everything you know about asset allocation is wrong.
Strong words indeed.
The unprecedented seems to happen all too frequently in financial markets. Is there something wrong with the way financial advisors build their clients' portfolios?
Modern Portfolio Theory (MPT) has been the very bedrock of investment management and, more specifically, portfolio construction and asset allocation, for decades. To oversimplify, one might explain MPT in this way: It is literally a mathematical proof for the idea that you shouldn't put all of your investment eggs in one basket. According to MPT, a portfolio of non-correlated assets — distributed across the risk spectrum — can lower the overall risk of a portfolio.
Of course, MPT has been picked apart by legions of critics over the years. But suddenly, in the aftermath of the recent stock market debacle — in which nothing seemed to work at all — critics of MPT are gaining currency.
The very foundation of modern asset allocation just doesn't work, they say.
Enter “Post Modern” Portfolio Theory (PMPT).
The debate between believers in the two different approaches to portfolio construction centers around how they define risk, and how that risk influences returns. MPT models risk using standard deviation above and below expected returns (also called mean variance). PMPT models risk using only standard deviation below expected returns (semivariance). In other words, MPT assumes that there is such a thing as upside “risk,” whereas PMPT proponents believe that only downside risk matters to investors.
This difference seems to give PMPT modeling greater power to predict disasters. In fact, applying MPT's concept of standard deviation to the monthly returns of the S&P 500 indicates a monthly loss greater than 12.8 percent has nearly no chance of happening. But it has occurred 12 times since 1926.
PMPT, say supporters, allows for last year's upset because it measures asymmetrical return distributions.
It’s a Post Modern World.
When the world was presented with Mean Variance Analysis [the basis of MPT] for looking at risk/return, it was the first of its kind back in 1952. No one had seen nor done anything like that before.
However, problem with the mean variance approach and what is known as the Capital Asset Pricing Model was that it assumed that every investor has the same objective. And that's just not true.
What is risk? To many, it is essentially the fact that we don't know what's going to happen, good or bad.
In short, predicting the future is impossible — though both MPT and PMPT still try to do this with modeling.
A major difference is that MPT assumes all investors have the same investment objective: to maximize the expected return for a given level of risk as measured by deviations around the mean. And so, for example, many retirement calculators suggest that 40 year olds who claim to have moderate risk tolerance plunk 40 percent of their assets in fixed income — which assumes these individuals, whether janitor or executive, will have exactly the same goals.
Subscribers to PMPT say, conversely, that investors have different and often very specific goals. The focal point should not be the maximum return possible given a certain level of risk, but rather the rate of return that must be earned in order to accomplish these specific investment goals, such as retirement or paying for college tuition, with minimum risk.
The risk, then, is defined as the possibility that the investor will be unable to accomplish the goal. As a result, returns below the target rate of return (“downside risk”) incur risk; returns above the target do not. With client portfolios suffering some of the largest losses in a generation, wouldn't everyone want a better handle on downside risk?
Don’t get me wrong. I do not have the audacity (nor the post graduate degrees) to suggest that MPT is wrong. The trouble I have is in the input variables. We've been using long-term averages for inputs. Historic averages have no predictive power at all. We’re told that by the very same people who expound on the virtues of MPT.
Indeed the concept of average expected returns, a central assumption in MPT, has taken a huge whack in the wake of the worst bear market in years, a bear so savage that it wiped out 12 years of equity returns in 16 months. Until now, who would have imagined the following could be true: Between 1969 and 2009, investing in 20-year Treasury bonds yielded better returns than investing in the S&P 500, according to research provided by Standard and Poor.
So much for the idea that over the long term, greater risk means greater reward.
Just food for thought.
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