Talk about data pertaining to your investments and there is no better, more comprehensive collection of plots than what JP Morgan Asset Management publishes in their Guide to Markets report each year. Most stuff is pretty self-explanatory but what’s the point of simply copying and pasting the data without some interjections from yours truly. So here we go in the order of what I find fascinating…
Looking back, the dot-com bubble was pure insanity. S&P 500 had a forward P/E of 27.2. That’s an earnings yield (E/P) of 3.7%. You could have made almost twice that by not taking any risk and parking your investible cash in a 10-year Treasury bond yielding 6.2%. Compare that to the peak before the housing bubble burst in Oct of 2007. The earnings yield of S&P 500 was 6.3%. That against the 10-year Treasury yielding 4.7% and you could have made a case that you were at least getting compensated though not generously for the equity risk you were bearing right before everything fell apart.
So do we have a deal now? S&P 500 earnings yield today is 5.5%. That against the 10-year Treasury yielding a measly 2.4% tells us that you are still better off staying with equities unless of course you are in retirement and are relying on an income stream from your portfolio.
So there’s a negative correlation between forward P/E and the returns you can expect in the future. No revelation there. And as expected, the scatter in the 1-year returns is quite a bit higher than that same scatter for 5-year annualized returns. For the statistically inclined, that is the Central Limit Theorem at play. And R-square show how good a fit the regression line has with the data and quite naturally, the fit for the 5-year annualized returns is better than with the more scattered 1-year returns as evident from the higher R-square number with the 5-year annualized data.
But in both cases, the future returns are expected to be in the single-digit realm based on the valuations we face today. And that’s why you diversify into many different types of investments which hopefully mitigates the impact of a single low-yielding investment.
Barring high-cost areas like the SF Bay and others around the country, the housing affordability situation looks great. But then there is a 1:1 correlation between that and the mortgage interest rates. So what happens to affordability when interest rates rise? And what happens to home prices when interest rates rise? Probably not what we desire especially considering that home prices relative to income ratio is close to the highest it has ever been. But there’s some solace in the fact that the lending standards are stricter, decreasing the risk of potential defaults but then a significant contraction in the economy can change that and hence everything.
50% of our national budget goes to spending on what some call ‘entitlements’ (Social Security + Medicare + Medicaid). And growing.
Those stagnant wages…
Low inflation and hence the resulting low interest rates. The headline CPI (Consumer Price Index) is the true CPI we as consumers feel from day to day. Core CPI excludes the effects of seasonality and the impact of the often volatile food and energy prices.
Best time to buy stocks is when no one wants to buy anything…
Just starting to come out of an era of ultra-cheap money. But interest rates are unlikely to move much if inflation remains low. The unintended consequence of all this easy money is that it creates asset bubbles because all this money has to go somewhere. And that is what we are likely experiencing with pretty much everything including of course the present day Tulip bubble i.e., the crypto-mania.
The flattening of the yield curve suggests investors have confidence that the Federal Reserve will be able to mop up all that liquidity they have injected into the economy in light of the financial crisis in time and not have the economy go through bouts of excessive inflation. You would only lend money for 30-years at 2.7% if you really believed that inflation down the road is expected to be tame. That was not the case in December of 2013.
On why loading up on long-term bonds is fraught with a significant risk of losing a lot of money in today’s low interest rate environment. And we thought stocks were risky.
People buy crazy shit when times are good. That’s evident from the spread to worst curve. But only when the tide goes out will we discover who’s been swimming naked…paraphrasing the Oracle of Omaha.
Diversifying globally with your equity portfolio is a given but diversifying your bond portfolio is equally important. Better yields with oftentimes low to negative correlations offer true diversification benefits.
If returns is all we cared about then loading up on emerging market stocks is what we should have done. But what we should care for is better risk-adjusted returns, not just better returns because we know that when we start with a dollar invested in an asset class with greater volatility (standard deviation), we could end up with a lower $ value than if invested in a comparable asset class with lower standard deviation.
Half the world’s equity market value resides outside the United States which does not necessarily mean that you need half your money invested abroad though a truly efficient portfolio will require that. But some amount of exposure to stocks in other countries is almost a requirement. And correlations are at an all-time low between US stocks and international stocks which means that you get paid to diversify internationally.
And hedging currency exposure defeats the purpose of international diversification because sometimes, a big chunk of your gains (and sometimes losses) can be attributed to the relative movement of your home country currency versus other currencies. And hedging costs money so don’t hedge.
And cheaper valuations abroad though sometimes things are cheaper for a reason.
The benefits of diversification. Not too hot and not too cold, just right.
Time in the market is more important than timing the market. Anything can happen in a year but you stretch that timeframe to say five years and you have to try real hard to lose money.
That average investor again. Always a hair above inflation and all attributed to His (stressing on the His) impulsive behavior. And REITs are almost mathematically guaranteed to not repeat that performance so don’t even try.
How the markets have humbled these institutional money managers. In 1999, 83% of the pension fund managers assumed that they’ll be able to generate returns in excess of 8.5%. Today only 2% do. In 1999, only 2% of the pension fund managers assumed returns below 7%. Today 59% do.
And 41% of the pension fund managers today still have 7% return as a minimum baseline assumption. Not sure what they are smoking especially considering the interest rate environment we find ourselves in because it’s one thing to assume that rate of return for retirement distributions say 20 years out but it’s a completely different ball game for you as a pension fund manager where you not only have to invest for growth but also for income to pay out distributions to employees who are currently retired.
The not so desirable home country bias I say. And regional bias. Folks on the West coast tend to invest more in technology stocks than folks in the Midwest. The Northeast is heavy on financials whereas the South in energy related investments.
Your portfolio declines by 20% and it takes a 25% gain to break-even. A 40% decline requires a 67% gain and a 50% decline a 100% gain. And it could take a while for those gains to materialize. So minimizing downside risk is critical especially in retirement where you are relying on that portfolio for income. Because you might have planned for that money to last say 30 years but you could run out in 10 years with one bout of a major market decline…like what we had during the global financial crisis.
So there, all that I could glean from this excellent compilation.
Data Source – Guide to the Markets, J.P. Morgan Asset Management
Image credit – Pixabay