A hedge fund that I oversee for my family office client had the following energizing comment in the fund's most recent quarterly letter:
There is no secret sauce for successful investing beyond a proven process and humility.
Certainly a number of hedge fund managers have been humbled recently by persistent underperformance against the S&P 500 as this unmanaged index marches ever higher. For example, the Dow Jones Credit Suisse Long-Short Hedge Fund Index has gained only 4.3% year-to-date through September 30, 2017 compared to a total return of 14.1% for the S&P 500. Despite the generally exorbitant compensation in the industry, I have some empathy for hedge fund managers that have consistently underperformed the S&P 500 because they've employed a risk mitigation, hedging discipline of shorting richly valued stocks (a bet that a stock price will go down) with flawed or failing business models and/or inferior management. You lose money shorting a stock if it rises in price for speculative, technical, or other reasons despite its rich valuation and perceived poor fundamentals. This year a broad swath of hedge fund managers' egos have been left dazed and confused by the irrationality of today's markets.
I believe the hedge fund manager's reference above to a "proven process" is a reference to the proving grounds of a sustainable investment approach of performance measured over a full market cycle - both bull and bear phases. The rigor and discipline of an investment process is only truly tested in a period of bearish market volatility and declining prices. Like great women and men, it is in the trial that an investor is made. Just like precious metals in a furnace it takes intense heat and pressure to reveal the inherent beauty and shine of an investment process.
Since its founding in 2005, Servant Financial's primary investment objective has been to take a risk aware approach to preserve client capital and maintain the real value of portfolios while growing capital over the long-term. Our investment strategy provides for the essential tenets of a fiduciary driven approach by providing broad diversification, low transaction costs, low portfolio turnover, and tax efficiency.
We achieve these investment objectives through risk-based asset allocation and a core passive index strategy. We overlay active management elements through a relative value discipline among asset classes and employing select active fund and stock selections.
As we've written about frequently in the past, investors have generally been penalized for taking a global, broadly diversified investment approach. Simply stated, with the benefit of hindsight investors would have significantly outperformed by being solely long U.S. equities over the last eight years. This issue was explored in a recent article from PIMCO entitled "Are Diversifying Assets Up Next In The Return-Seeking Cycle?". The article cites some stark comparisons of performance across asset classes:
Since the lows of the global financial crisis in March 2009, U.S. stocks (proxied by the S&P 500) have returned 270%, or 16.8% annualized, outpacing every other major market over that period. Contributing to that outperformance were highly differentiated returns among asset classes, particularly in the three calendar years following the “taper tantrum” sparked by comments from then-Fed Chairman Ben Bernanke. Starting in 2013 and through 2015, the S&P 500 Index gained 52% cumulatively, whereas core bonds returned 4% (proxied by the Bloomberg Barclays U.S. Aggregate Bond Index) and an equally weighted basket of diversifying assets actually lost value, returning −12%. In other words, diversifiers lagged U.S. stocks by 64% for the 2013–2015 period.
Futurist and inventor Elon Musk's statement that "There's a one in billions chance we're in base reality" immediately came to mind. In summary, Elon took game theory to the next level when he stated that he believes we are living in some advanced civilization's computer simulation. Essentially, the world in which we live is the ultimate in fake news and our markets are a form of entertainment called extreme financial games. When one looks at this issue through the lens of valuation, I think there is something to be said for Musk's argument that U.S. equity markets are some form of computer simulated entertainment.
Within this realm of extreme financial gaming, Servant's investment process has been dynamic and interactive and has consistently included forward-looking expected return inputs to supplement the longstanding investment advisory practice of using past returns to forecast future returns. Research Affiliates recently posted an article entitled, "The Most Dangerous (and Ubiquitous) Shortcut in Financial Planning" - using historical returns to forecast the future is the shortcut methodology. I'm unsure who is the puppet master in this extreme financial game, but I'd like to use the rest of this feature article to update investors on S&P 500 valuations and expected future returns by summarizing the work of three investment research firms that we religiously follow that use forwarding-looking return forecast models.
The first research firm expected return forecasts we'll look at are from GMO. GMO is a global investment leader with expertise in managing multi-asset class strategies as well as focused strategies in a number of specific asset classes. GMO's investment approach seeks to identify asset classes and securities where investors are paid to take risk and utilizes a long-term investment horizon, a belief in the power of mean reversion, discipline, conviction, and a commitment to research (emphasis added). As we've covered in the past, mean reversion is a key assumption in GMO's asset class forecasts. GMO assumes asset class valuations will revert to their historical mean valuation levels over a 7 year forecast period. For the S&P 500 this approach implies that GMO expects that the current Shiller price to earnings (PE) of ratio 31.3 times at the 100th percentile of its historical valuation range would revert to approximately the 50th percentile over the next 7 years. In other words, the lower valuation multiple applied to the S&P 500 over time is expected to result in mark to market valuation losses by GMO.
GMO recently published their 7-year asset class real return forecasts as of September 30, 2017. As you can see from the chart below, GMO expects that investors will lose money over the next 7 years on a real basis (after inflation) for all asset classes except emerging market equities (+2.4%), emerging market debt (+0.4%), and cash (+0.1%). U.S. large cap (-4.1%) is expected to be the worst performer over this forecast period.
The next body of valuation research we will look at is from Research Affiliates. Research Affiliates is a global leader in smart beta and asset allocation. Dedicated to creating value for investors, Research Affiliates seeks to significantly impact the global investment community through their insights and product innovations. The scatter plot below shows Research Affiliates' 10-Year expectations of risk and real return for portfolios and asset classes. Follow this link above to Research Affiliates' website where you can click each of the individual dots, or make selections from portfolio and asset lists to get more information about each portfolio or asset class. The portfolios connected by the dashed line below represent efficient, highest return per unit of risk, portfolios. These efficient portfolios are governed by a set of diversification standards which can be seen by clicking the "Efficient" label in the portfolio list at their website.
These expected returns are based on a set of routines which model both expected cash flows and changes in asset prices (reversion to the mean), and not by extrapolating returns of the past (pervasive short-cut approach used by most financial advisors). You can learn more about Research Affiliates methodology for valuing assets here.
In general, I would characterize Research Affiliates' methodology as a more robust version of GMO's basic methodology described above. Note that Research Affiliates projection period is 10 years versus GMO's 7 year forecast period. There are obviously other significant differences in assumptions and methodology as you'll note for example that Research Affiliates has projected a 10 year real return for emerging market equities of 6.3% with volatility of 22.9% compared to GMO's 7 year expected real return of 2.4%.
The third and final research firm's work we'll look at is Hussman Funds. Hussman Funds was founded by John Hussman, an economist, stock market analyst, and mutual fund owner. He publishes a weekly market commentary and is broadly known for his public criticism of the U.S. Treasury and the Federal Reserve policies and for predicting the 2008-2009 U.S. Recession. He has written extensively about the extreme valuations of the S&P 500 and other asset classes precipitated by Fed monetary policies and, not surprisingly, is predicting another market crash and financial crisis.
Like GMO and Research Affiliates, Hussman has performed extensive investment research and valuation analysis. In his latest weekly commentary dated October 9, 2017 is entitled "Why Market Valuations are Not Justified by Low Interest Rates." Hussman describes how his team has back tested some 15 different valuation approaches and determined the methodologies that have the highest correlation and predictive value for future expected returns. One of his favorite methodologies is Margin-adjusted CAPE (cyclically adjusted price earnings/Shiller PE). Hussman's introduction to this method is as follows:
The chart below is based on (Hussman's) margin-adjusted variant of Robert Shiller’s cyclically-adjusted PE (CAPE). Specifically, the CAPE (calculated here as the ratio of the S&P 500 to the 10-year smoothing of inflation-adjusted earnings) is multiplied at each point in time by a factor equal to the 10-year smoothing of corporate after-tax profits to GDP, divided by the historical norm of 5.4%. The resulting measure is similar to the S&P 500 price/revenue multiple, the ratio of market capitalization to corporate gross value-added, and other measures that share a correlation near 90% or higher with actual subsequent 10-12 year S&P 500 total returns in market cycles across history.
As expected, the (log) margin-adjusted CAPE acts as a “sufficient statistic” for actual subsequent S&P 500 total returns, particularly on horizons of 10-12 years (which is the point where deviations from historically normal valuations most reliably damp out). Also as expected, adding additional information about interest rates (green) does virtually nothing to improve the reliability of the resulting projections; a result that can be understood from our earlier valuation examples. If anything, low interest rates actually worsen expected future market returns here. If extreme valuations were not enough, depressed interest rates suggest the likelihood of below-average economic growth as well.
As you can tell by the green and blue lines in the bottom right corner, Hussman expects negative nominal returns for the S&P 500 over his 12 year forecast period.
The last and perhaps most telling chart on current extreme valuations below is Hussman's margin-adjusted Shiller PE. Since the current profit margins of the S&P 500 are well above the historical norm of 5.4%, Hussman estimates the Margin-adjusted Shiller PE is something like 44 times today or significantly in excess of the 40 times for the 1929 market bubble, the dot.com bubble of 2000 at 41 times, and the current Shiller PE of 31.3 (without making an adjustment to normalize margins).
By these metrics, we are clearly in an extreme financial game simulation or some other artificially created financial and market situation. The question is are these "fake" markets of an alien origin or do they emanate from Fed monetary policies as Hussman and other market historians would vehemently argue? My intuition is that it is Fed induced rather than E.T., the Extra-Terrestrial, playing an advanced video game.
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