No Markets Aren’t Revisiting 2008

 Yes, markets have beaten up everyone so far this year. Investors are looking for answers and struggling to identify a culprit — just read the headlines. According to my Bloomberg colleagues, some observers are even beginning to wonder whether a repeat of the nightmarish 2008 meltdown is underway.

All of this sudden soul-searching is odd. Overseas markets have been in turmoil for much of the last two years. The MSCI EAFE Index returned a negative 4.5 percent to investors in 2014 and a negative 0.4 percent in 2015. The MSCI Emerging Markets Index returned a negative 1.8 percent and a negative 14.6 percent, respectively, over the same period.

There hasn’t been much confusion over the declines overseas, and for good reason: the troubles are well known. China is slowing and a hard landing is not out of the question. Europe is struggling to stimulate growth. Geopolitical tensions are high. Energy prices have collapsed, devastating regions that are heavily dependent on energy production and export. Overseas markets have repriced to reflect these risks.

There is one recent and significant change: U.S. markets are now in the process of repricing, too. Until this year, the U.S. had thrived while investors took a wary view of overseas markets. The S&P 500 Index returned 13.7 percent to investors in 2014 and 1.4 percent in 2015. Investors seemed to view the U.S. as an island of prosperity, unaffected by overseas risks, but in a globalized economy thinking that way is a fantasy.

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On Goldman’s Rosy Market Outlook

For anyone suffering whiplash after following the markets in recent months, Goldman Sachs’s well-known strategist, Abby Joseph Cohen, recently offered a soothing forecast: She pegged the S&P 500’s fair value at 2,100. As of this writing, the S&P 500 is trading at about 1,896.

Cohen didn’t show how she arrived at her valuation, but the calculation is straightforward: you use earnings per share multiplied by the fair value, price-to-earnings ratio. Et voila.

Problems arise and predictions vary, however, because neither EPS nor the fair value P/E is obvious — and the resulting fair value can vary wildly depending on the assumptions used for each of those measures.

To see the effect of EPS on fair value, let’s assume that the fair value P/E for the S&P 500 is 16.5. Looking at S&P’s earnings data, the forward operating EPS of $126 yields a fair value for the S&P 500 of 2,079. The forward, as reported EPS of $119 yields a fair value of 1,964. The trailing operating EPS of $106 yields a fair value of 1,749. The trailing as reported EPS of $95 yields a fair value of 1,568. (Operating EPS excludes non-recurring items; as reported EPS doesn’t exclude non-recurring items.)

By using the most conservative of those valuations, we’ve already shed 25 percent from Goldman’s estimate of fair value – a real life decline that would make investors weep – and we haven’t even normalized earnings yet.

If we then cyclically adjust earnings using a ten-year trailing average, the normalized operating EPS of $88 yields a fair value of 1,452. The normalized as reported EPS of $76 yields a –- gasp –- fair value of just 1,254.

The fair value P/E is as elusive as EPS. A common proxy for fair value P/E is the historical average P/E, and reliable U.S. stock data is compiled by Nobel laureate Robert Shiller going back to 1871. But which historical period should we use? From 1871 to 1945, the U.S. was effectively an emerging market. Soon thereafter, the U.S. joined an elite club of developed countries and eventually became the most creditworthy country in the world.

Investors appropriately priced the U.S. more richly in the “developed” period than in the “emerging” period. To see the effect of fair value P/E on the resulting fair value, let’s assume that EPS for the S&P 500 is $126. The average one-year trailing P/E since 1946 is 16.8, which yields a fair value for the S&P 500 of 2,117. But the average one-year trailing P/E since 1871 is 15.4, which yields a fair value of 1,940 – nearly a 10 percent haircut from the post-1946 figure.

One way around the problem of deciding which set of historical data to use is to build a fair value P/E from the bottom up (as I recently did for China) by using the sum of inflation, real productivity growth, and dividend yield.

The IMF estimates that U.S. inflation over the next five years will be 2.2 percent annually, and that real productivity growth will be 1.7 percent annually. The current dividend yield for the S&P 500 is 2.3 percent. The sum of these three variables is 6.2 percent, the inverse of which implies a fair value P/E of 16.1.

By these lights, Goldman’s fair value for the S&P 500 of 2,100 is aggressive. In order to get there, one has to assume the most optimistic earnings results for 2016 – a forward operating EPS of $126 – and a generous fair value P/E of 16.7.

Cohen may be right, of course, but investors would be wise to think critically about her assumptions. Cohen is no stranger to bullish calls. Near the peak of the tech bubble in late 1999, she believed that the market was near fair value. (Cohen says that in March 2000 she suggested that clients sell stocks.) In January 2008, Cohen predicted that the S&P 500 would close the year at 1,675. Spoiler alert: It didn’t.

My Bloomberg colleagues reported last week that the U.S. is showing worrisome signs of decline, including weakening retail sales, manufacturing, and wholesale prices. The S&P 500’s brutal selloff so far this year appears to echo those concerns, and 2,100 seems to be increasingly farther way, in my estimation.

So I’m inclined to use a more cautious valuation when looking at the S&P 500. I’ll take the normalized operating EPS of $88 and the fair value P/E of 16.1, and peg the index’s fair value at 1,417.

But investors need not accept Goldman’s or my estimation of fair value. Given how readily available good data is these days, every investor can form his or her own judgment about EPS, fair value P/E, and the resulting fair value for the S&P 500.

What’s your number?

Source: Bloomberg Gadfly, https://bloom.bg/2yX7uL7

Why Did the 6,400% Man Stop Trading?

Martin Taylor of Nevsky Capital said goodbye to investors last month in a letter that, as my Bloomberg colleague Mark Gilbert noted, signaled that Taylor may have “lost his appetite for the daily fight to outsmart the market.”

Despite racking up a return for his investors of more than 6,400 percent between 1995 and 2015, Taylor said he decided to hang up his cleats as an emerging markets manager of Nevsky and its predecessor because “what we have done has worked brilliantly for twenty years but does not work any more.”

Might there be more to it than that?

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Don’t Worry. Just Diversify.

Investors no doubt want to forget 2015. As my Bloomberg colleague Lu Wang aptly put it, 2015 was “The Year Nothing Worked.”

Well, not nothing. Diversification worked. If you were invested in a diversified portfolio in 2015, you didn’t make money, but you were protected from very painful declines in some corners of the global market.

The 60/40 diversified portfolio below, for example, was down 1.4 percent in 2015 – a year in which two of its components, emerging market stocks and commodities, were down 14.6 percent and 32.9 percent, respectively. One virtue of diversification is shelter from the storm, and it delivered in 2015.

So why fret? For starters, diversified portfolios have barely budged over the last two years. The portfolio above has only returned 2.2 percent annually to investors since 2014. On the other hand, the S&P 500 Index – the most widely followed market barometer by U.S. investors – returned 7.4 percent over the same period. Investors feel left behind.

Warren Buffett might have you do otherwise, though: trade your diversified portfolio for an S&P 500 Index fund. Buffett has already declared that 90 percent of the money he leaves to his wife will be invested in Vanguard’s S&P 500 Index fund (with the remaining 10 percent invested in short-term government bonds, presumably for liquidity). 

Buffett is a well-deserved member of the investment world’s version of Mount Rushmore, but he’s wildly wrong to put almost all of his hard-earned eggs in the S&P 500 basket. I’m not the only one who thinks so. I’m not aware of a single portfolio built almost entirely on the S&P 500 – not Yale’s, not CalPERS’s, not the hallowed private wealth portfolios of Goldman Sachs, not the portfolios of your friendly local financial planner.

This is all for good reason because diversification, by insulating investments from market vagaries, creates more efficient portfolios over time. The 60/40 portfolio above returned 8.8 percent annually since 1988 (the first year for which returns data is available for all of its constituents), with a standard deviation of 10.7 percent and a Sharpe Ratio of 0.52. The S&P 500 Index returned 10.3 percent over the same period, with a standard deviation of 17.8 percent and a Sharpe Ratio of 0.40. (Standard deviation reflects the performance volatility of an investment, while the Sharpe Ratio is a gauge of risk-adjusted returns; a lower standard deviation indicates a less bumpy ride, and a higher Sharpe Ratio indicates that investors are more adequately compensated for the volatility they take on.)

Note, obviously, that the S&P 500 was both more volatile and less rewarding than the diversified, 60/40 portfolio.

The S&P 500 didn’t even provide the highest absolute return during the period! The MSCI Emerging Markets Index returned 10.5 percent annually since 1988, edging out the S&P 500 Index’s 10.3 percent annual return. This is no fluke. There are numerous asset classes that provide higher expected returns than the S&P 500 (among them asset classes that target factors such as value, size, quality, momentum and liquidity.)

A hundred years ago diversification meant assembling a portfolio of individual U.S. large cap stocks and bonds. Today diversification means assembling a portfolio of asset classes that stretch across geography (U.S., international, emerging, frontier), size and quality (large cap, small cap, investment grade, high yield), and the capital structure (bonds, mezzanine debt, preferred stock, common stock).

As the number of asset classes proliferate, so do the number of strategies that attempt to assemble them into a coherent portfolio. They go by names such as Markowitz (after Nobel Laureate Harry Markowitz, who introduced mean-variance optimization in the 1950s), Strategic-Tactical, Global Tactical Asset Allocation, Black-Litterman, Global Macro, and Risk Parity. There also are newer, unnamed strategies, such as those that allocate on the basis of valuation or momentum — or both.

Multi-asset portfolios are commonplace today, but they generally rely on a single strategy. Just as a multi-asset portfolio is more efficient than a single-asset portfolio, it stands to reason that a multi-strategy portfolio would be more efficient than a single-strategy portfolio. The reason is simple: When one strategy isn’t working, the others may pick up the slack.

Rather than revert to a single asset such as the S&P 500, my guess is that in the not distant future, portfolios will become multi-strategy rather than merely multi-asset. These multi-strategy portfolios will be a step forward, but no silver bullet. There will still be years when nothing works. There will still be periods when the S&P 500 is the best performer. In those periods the challenge will still be not to look at the S&P 500 with envy.

And if anyone tells you that nothing worked in the markets last year, tell them that you know of one thing that did: diversification.

Source: Bloomberg Gadfly, https://bloom.bg/2gW4eLs

Stop Freaking Out About China

With China in the midst of what appears to be a significant economic slowdown, investors are questioning their faith in one of the new century’s great growth stories. They shouldn’t abandon China just yet.

First, some perspective. China was never going to string together an uninterrupted record of astounding annual growth. Despite all the hyperbole in recent years about China’s prowess and coming global dominance, not even China is exempt from the business cycle. But the current contraction will be followed by another expansion, unless you believe that China is going out of business — and no one who is a serious student of the country and its economy believes that. 

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Show Me the Money

Remember: Stock rallies are ultimately dependent on corporate earnings growth. As Ben Graham, the father of security analysis, reputedly said, “In the short run the market is a voting machine, but in the long run it’s a weighing machine.”

What the market weighs is earnings.

So how to assess “abnormal items” (such as merger costs, natural disasters, one-time sales, or any other unusual event) that skew earnings?

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So About Those Big Corporate Profits

Jeremy Grantham, an astute investment strategist, recently raised doubts about American exceptionalism in such areas as health care and education. But as my Bloomberg News colleagues noted in an article about Grantham’s concerns, the U.S. has managed to maintain its exceptionalism in at least one category – making money.

Corporate America has been handsomely profitable since the financial crisis that erupted in 2008, outstripping the performance of overseas competitors. The earnings per share of U.S. companies, as represented by the S&P 500 Index, have grown by 105 percent since 2008. In the developed world outside the U.S., as represented by the MSCI EAFE Index, earnings per share have grown by 30 percent over the same period. In emerging markets, as represented by the MSCI Emerging Markets Index, earnings per share have grown by 8 percent over the same period.

Such success was hardly a forgone conclusion seven years ago. At the height of the financial crisis, the survival of many U.S. companies – to say nothing of their future profitability – was in doubt. By contrast, emerging markets were lauded for their growth and comparatively low levels of debt.

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There’s No Place Like Home

Jason Zweig recently suggested that homeowners make far less money selling their houses than they believe. He cites Yale University economist Robert Shiller’s data, which finds that “real estate generally keeps pace with inflation but seldom offers any return premium above that.”

Homes have done a bit better than that, but not by much. The S&P/Case-Shiller U.S. National Home Price Index, which measures the changes in value of single-family homes, has grown at a real rate of 1.1 percent annually since 1975. In reality, even this pittance overstates homeowners’ fortunes since it doesn’t account for the myriad expenses that also accompany homeownership and eat away at returns.

So how did homes get confused with goldmines? It turns out that a short-lived period of unusually high returns is to blame. As expected, that period coincides with the boom years of the real estate bubble, but the seeds were planted during the tech bubble that preceded it. This becomes apparent when looking at the NHPI’s rolling ten-year real returns.

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Vanguard Should Get Active

As my Bloomberg News colleagues reported earlier this week, the financial juggernaut known as Vanguard added $185 billion to its low-cost and passively-managed funds so far this year, “which puts it on pace to…” wait for it, wait for it, “…bring in more money in one year than any asset manager in history.”

Vanguard deserves its success. It’s brought low-fee, principled investing to the masses in a singular and admirable way.

According to Bloomberg, the average asset-weighted fee of a Vanguard fund is 0.13 percent, compared with 0.66 percent for an active mutual fund. On $185 billion, this translates into fee savings of nearly $1 billion this year alone – a boon to Vanguard’s legions of investors.

But as the industry leader, there’s much more that Vanguard could and should do.

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Diverging Markets

Everyone has grown accustomed to thinking about emerging markets as a monolith — a collection of undifferentiated countries aspiring to the big leagues, with all of the heft and stability of more developed economies.

Emerging markets share similar traits, oftentimes the market prices them similarly, and so they all get wrapped into the familiar and popular one-size-fits-all basket called THE EMERGING MARKET FUND.

Today, that’s the wrong way to think about emerging markets.

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