September 27, 2013
By Steve Blumenthal
I’m in NYC this week for meetings and a few media interviews. I met with Gregg Greenberg at TheStreet.com this morning and tried my best to explain why Emerging Market portfolio exposure remains important (which is tough to do in 3 minutes). Later today, I have an interview with Barron’s and I’m really looking forward to being with Bloomberg Radio’s Pimm Fox. He has such a great personality.
The media game plan today is to share my thoughts on current valuations, the economy, the probable returns for both stocks and bonds over the coming 10 years, talk about “tactical” investment strategies, define what tactical means, and show how to combine them into a stock and bond portfolio.
“Tactical? What in the world is that?” I was recently asked. I forget how far we have come over the years and how confusing this relatively simple investment approach is to most investors. Or is it that I am simply a passionate quant geek oblivious to the real world? “Passionate geek” – I hope my kids don’t see this piece. Anyway, after the discussion on current valuations, at the bottom of this piece I share with you some thoughts on exactly what tactical means.
Overvalued
The market is expensively priced by almost every credible valuation metric I look at, with one exception, Wall Street forward earnings estimates. I don’t buy into the forward guestimate game. Give me something factual as a risk guide. Earnings mean revert through business cycles and Wall Street has a tendency to adjust too late.
This week I came across the following valuation chart from Ned Davis Research. Here NDR creates a normal valuation line by calculating six independent valuation lines based on dividends, earnings, cash flow, sales, CPI-adjusted PE’s and trend. Each month represents the median of these six measures.
As investors, we want to buy investments at a good value and be cautious or sell assets when they reach an overvalued state. They are clearly overvalued today setting up a period of low returns. Could stocks go higher like they did in the late 1990s? Of course, but they could normalize like they did in 2000-02 and 2007-09.
In the chart below, note the percent gain after 1, 2, 3 and 5 years when the data showed the market to be overvalued above a reading of 20 (red circle, red arrow). Also note the returns when valuations showed the market to be undervalued – a reading below -20. When would you rather add money to equities? Give me the -20 “Normal” valuation please.
This next chart is probably becoming a familiar chart to you. Here PIMCO and Research Affiliates show the Estimated Forward 10-year return on equities to be 5.40% and the Forward 10-year 60/40 return to be just 4.10%. Low beginning dividend yields, low inflation and low beginning bond yields are the primary culprits driving expected future low returns.
The next two charts reflect the GMO and Hussman forward looking returns for multiple asset classes. Note that GMO predicts negative annualized returns for US Large Cap and US Bonds while Hussman sees just a 3.2% annualized return for the next 10 years. Not great.
Any way you look at it, whether NDR, Research Affiliates, GMO, or Hussman, today is not the opportune time to switch into equities. We are experiencing overvalued markets combined with unmanageable debt, unmanageable entitlements and global central banks manipulating markets. We are in uncharted waters. These are unusual times.
While the S&P 500 is up nicely so far this year, be careful not to project yesterday’s returns forward. We humans do have the tendency to chase into markets at just the wrong time, psychologically feeling confident after the move. It was tech in 1998-99 and housing in 2007-08. Another bubble has inflated and this one is in bonds. I recommend doing the opposite…hard to do.
Broadly diversify and add other risk streams into your portfolio construction. Managed futures have underperformed for three years. Does that mean it will underperform the next three? Tactical has been ok to mixed. Alternative long/short has underperformed.
If I asked 100 advisors which asset class, S&P 500 or emerging markets stocks, would be the best performer year-to-date, the majority would have said emerging markets (EM). EM is down while the S&P 500 is up 20%. Should you sell out of EM and buy into the S&P? Many are doing just that. I believe EM should be in portfolios and I think it’s better to rebalance (dollar cost average in and hold your targeted weighting). This is tough to do when your client is unhappy and looking for change.
Note GMO’s 7 year return estimated return for EM in Chart 3 above. It is 7.0% for EM vs. -1.5% for US Large Cap (S&P 500). Hard to buy when everyone else is selling but it is usually the right thing to do.
I don’t know any investor who can always pick the winners – all the time. It is why we diversify and why I’m a big proponent of including Tactical, Managed Futures and other types of liquid return streams into portfolios. This leads me to conclude today with a note on Tactical.
In a recent interview, I was explaining why I believe 33/33/34 represents a balanced portfolio (vs. the old 60/40). I explained that the 34% allocation bucket should include liquid “tactical” investments. A puzzled look crossed the interviewers face and he said, “what in the world is tactical?”
The industry has evolved since I began my career in 1984. Commissions have come down from 15 cents a share to less than ½ of a penny. Individuals can trade for less than $10 a trade. ETFs and mutual funds have grown beyond what I would have imagined and provide you, me and all investors with tools to increase wealth. “All investments, bond included, have a number of modern-day weapons at their disposal which can be used to defend against higher interest rates,” Bill Gross wrote. I agree.
I explained that Tactical is simply planning and positioning to accomplish a purpose. Quarterly rebalancing is tactical. Choosing to allocate 60/40 or 33/33/34 (or any combination) is a tactical decision. Momentum investing, sector rotation and relative strength investing is tactical. Overweighting technology and biotech, increasing cash exposure and hedging against higher interest rates is a tactical decision.
I presented the following chart to share an idea as to how an investor might tactically hedge their equity exposure.
Note the points in time when the blue line (a 13 week EMA) crossed below the red line (34 week EMA) accurately signaling a cyclical bear period and when the blue crossed above the red signaling a cyclical bull. You could put a hedge in place or tactically reduce equity exposure and later remove the hedge or tactically increase exposure. I think this would have served most investors well.
The hard part is sticking to the plan. I believe strongly that if you broadly diversify your investment exposure and include tactical strategies into your portfolio, you will be in a position to not only grow your client’s portfolios but also smooth out the inevitable rough spots along the way. Find proven and deeply experienced managers.
Until overvalued equities become undervalued, overweight tactical strategies. I still favor 33/33/34 over 60/40.
I remember my summer in 1982. I spent a month of the floor of the NY Stock Exchange. I loved that experience and enjoy my frequent trips to the city. Today it is low 70’s, no humidity and absolutely picture perfect. I hope you are enjoying the beginning of autumn and have something fun set up this weekend. My daughter and 7 classmates are coming home for the weekend for the Kids with Cancer annual fundraiser. I can’t wait to see her.
Wishing you an outstanding weekend.
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax
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