Investing Landscape
This post summarizes the current investing landscape and will be continuously updated at different snapshots in time.
The focus is on broad asset class valuations and how investors should rebalance given market conditions.
Humans are semi-rational economic actors and history is replete with examples of assets that are overpriced / underpriced relative to economic fundamentals. There are entire books that recount the most memorable financial manias and crashes over the last few hundred years.
Humans have not become more rational economic actors over the years. The same psychological factors that caused financial manias and panics in the past still persist today.
It’s arguable that the tighter feedback loops, instantaneous information flows, and frictionless app trading platforms are empowering investors to act even less rationally. The meme-stock and cryptocurrency investing manias of 2021 are clearly based on “hot investment tips”, not rational economic analysis.
Some investors are good at getting into hot trades and jumping ship before the crash. Most don’t have the ability to identify the top and are left holding the bag.
Other investors gravitate to value investing, the opposite of the meme-stock game. These investors over allocate to the investments with poor returns that nobody else is talking about.
Value investors are especially motivated to avoid financial bubbles, which, like overpriced assets, can be spotted in realtime and avoided.
Lets take 1989 as an example:
- Japan was in the biggest stock market bubble in the history of stock markets.
- US equities were quite cheap.
- The 10-year US Treasury yield was at 8% and bonds offered an attractive, “risk free”, return.
Here’s what happened after 1989:
- The Japanese stock index (Nikkei) topped out at 39,916 in October 1989 and then commenced a multi-decade decline. The index bottomed at 7,973 in January 2003 and currently sits at 28,875 (as of June 2021). Most investors are not aware that 32+ year bear markets are possible.
- US stock market had amazing returns in the 90s
- US bond market also had amazing returns in the 90s
The 1989 Japanese stock market bubble was not hard to identify. Japanese valuation multiples at the time were higher than multiples at any point in the history of markets. It wasn’t a great mystery to identify irrational exuberance in the market in real time.
Your mission should be to understand valuations of major asset classes and plan your asset allocation accordingly.
Asset allocation
Your asset allocation is the biggest predictor of the future returns of your portfolio.
A portfolio that’s 20% stocks / 80% bonds has a much different expected return than a portfolio that’s 90% stocks / 10% bonds.
Your asset allocation should be a function of the following factors:
- willingness and ability to take risk (risk tolerance)
- time horizon
- asset class valuations
You should formalize your asset allocation plan with an Investor Policy Statement (IPS) that outlines your target asset allocation. Investor Policy Statements are especially important now because technological innovations are making it harder for investors to stay disciplined.
News cycles, information flows, and feedback loops are accelerating, but core human psychology is unchanged. Well know behavioral economics biases, like home country bias, have been observable for decades and are still omnipresent. Australians overallocate to Australian equities, Italians overallocate to Italian equities, and Americans overallocate to US equities. Modern investors haven’t read the behavioral economics research from the 1970s and adjusted their allocations accordingly.
Investors haven’t become more financial savvy either. Most investors still don’t know how to read financial statements, perform discounted cash flow analyses, or even understand the concept of valuation ratios as a high level.
Financial literacy can be learned. You can learn how to track core financial metrics and allocate your assets accordingly.
Understanding the valuation ratios that justify your asset allocation gives you psychological fortitude to act rationally when markets are volatile. Core human emotions can cause investors to make suboptimal decisions like selling in a market crash.
If you buy an asset because it has solid economic fundamentals, then you’ll be comfortable holding or even buying more in the event of a price downturn. It’s harder to hold in a downturn if you never understood the economic rational for the purchase in the first place.
The rest of the page focuses on economic statistics, but don’t underestimate the importance of psychology. Your personal psychology will temp you to make bad investment decisions at times. The madness of crowds will cause asset bubbles to inflate and crash.
Accept the limits of your ability to think rationally and how much is “you-specific”. Some people get anxious, lose sleep, and panic, even for slight market downturns. Other people love chaos and laugh at meltdowns. Make a rational plan, but embrace that “everyone has a plan till they get punched in the face” and controlling psychology is just as important.
June 2021
Certain financial assets are priced very expensively, especially in the United States.
Other financial assets are at multi-decade lows.
Here’s the current allocation of the Vanguard Total World Stock ETF:
- 11% emerging markets
- 17% Europe
- 12% Pacific
- 60% North America
Any deviation from the world market cap allocation is traditionally characterized as an “active bet”.
US Equities
The US equity market has outperformed the rest of the world significantly since 2008.
US equity outperformance coupled with home country bias has many American investors overallocated to US equities.
Recency bias causes investors to favor assets that have given them good returns recently and shun assets that have gone down recently. Recency bias causes investors to like their US equity holdings now.
The US CAPE is at the second highest level in history. The Price / Sales and market cap / GDP ratios are higher than ever in history.
Value stocks have gone through the biggest and longest drawdown in history. They’ve recently shown signs that they’re starting to bounce back.
The P/E ratio is currently 22.5, and Siegel thinks the earnings yield is the best predictor of future returns. The earnings yield (E/P) is 1 / 22.5 = 4.4% (real). Siegel is predicting a 4.4% real return for stocks going forward, which is lower than the 6.8% long term historical average return.
Arnott has a more pessimistic forecast for US equities. His asset allocation interactive tool is predicting 10-year annualized real returns of -0.8% for US equities.
The market cap weighted global index suggests a 60% allocation to North American equities at this time. A high allocation to an asset class that’s valued so highly seems risky. Perhaps a 30% allocation to US value stocks is more appropriate at this time.
Emerging Market Equities
Emerging markets outperformed US equities significantly from 2000-2007 and then underperformed US equities from 2007-2020. At the end of 2007, the EM CAPE was 38 and the US CAPE was 28. The June 2021 EM CAPE is now 15 and the US CAPE is 37. Oh how times have changed.
Investors were optimistic about the Brazil / Russia / India / China (BRIC) stocks from 2000-2007 and bid them up to high valuations. BRIC currencies also strengthened from 2000-2007. BRIC stock markets crashed during the Global Financial Crisis and again around 2011 when their currencies collapsed as well (Chinese currency has been much more stable than Brazilian / Russian currencies, which crashed).
Why were investors irrationally optimistic about BRIC countries in 2007 and why are investors irrationally pessimistic about BRICs currently? No good reason from what I can tell.
The Brazilian stock index had the same major components in April 2011 and January 2016. Why did the market view those companies as 75% less valuable in January 2016 (in USD)?
Superficial explanations don’t tell the true story:
- Zika virus, a mosquito borne illness, isn’t surprising in a country with the largest rainforest in the world
- A “corruption scandal” isn’t surprising in a country that’s one of the most corrupt in the world, as measured by the Corruption Perceptions Index
Investors were just irrationally optimistic about Brasil in April 2011 and irrationally pessimistic about Brasil in January 2016. These irrational though patterns extended to emerging markets in general.
The emerging market valuations are different now after 13 years of economic growth and stock market underperformance.
Certain investment advisors are now overallocating to emerging markets, given current valuations. Meb Faber invests 100% of his 401k in emerging markets and Rob Arnott has a 50% allocation to emerging markets deep value.
Most investing advisors are underallocating to emerging markets. The average emerging market allocation for US advisors is only 3%.
Given current valuations, seems like a 30-50% allocation could be justified.
European Equities
Gundlach is bullish on European equities for the first time since he started Doubleline capital 12 years ago.
EAFE is at a CAPE of 18, which is much lower than the US CAPE. Dollar weakening also bodes well for European equities.
Overall stock allocation
My risk tolerance is high, my time horizon is long, and I prefer investing in undervalued assets, so here’s my target asset allocation:
- US value: 25%
- EAFE: 25%
- Emerging markets: 50%
My portfolio will benefit from a rebound in value and if the dollar weakens.
Your action items
- Determine your current asset allocation
- Assess you risk tolerance and current valuations to create a target assess allocation that’s customized for your needs
- Reallocate your assets accordingly
US bonds
Real bond yields were 10% in 1984 and are currently -2.5%.
Predicted long bond returns:
- Siegel: -1%
- Arnott: -3.5%
Perhaps bonds still have a place in a portfolio for reducing volatility, but don’t expect US bonds to make you any money.
US Dollar
“The dollar is doomed with the policies that are currently being enacted.” - Gundlach
The twin deficits (trade deficit & budget deficit) should continue pushing the dollar lower.