Over the past few years there has been a loud and persistent chorus of complaints from market participants about the fact that markets are behaving like simple ‘risk on, risk off’ discounting mechanisms, where almost all of the risk seems to be emanating from a very small number of sources.
This article is about how central banks have orchestrated a large overshoot in asset prices, and what this means for likely future returns to stocks and bonds in particular. We’ve written on this topic before, but this article approaches the problem from the point of view of central bank policy rather than analyzing valuation metrics.
Imagine for a moment sitting at the kitchen table, steaming coffee in hand. The sun is streaming in the windows, bacon is popping in the pan, and Rover drops the paper at your feet. A brilliant Saturday morning by any measure, but today is extra special. Now you’re retired!
Let us preface this article by saying that we can’t for the life of us figure out why any investor cares about beating the market in the first place. To us, the whole concept of beating the market is a red herring. The only people who should be concerned with beating the market are investment managers themselves, because their compensation is directly tied to this specific objective.
Now that we are hip deep in our Dynamic Asset Allocation for Practitioners series (Parts I, II and III), it’s become evident that we may have skipped over some fundamental concepts in our rush to explore the more juicy material. This next series of posts is intended to lay the groundwork for how we think about the broader asset allocation problem.
We endorse the decisive evidence that markets and economies are complex, dynamic systems which are not reducible to linear cause-effect analysis over short or intermediate time frames. However, we are willing to acknowledge the likelihood that the future is likely to rhyme with the past.
Most investors miss the most important concept in wealth management because they are laser focused on returns as the primary benchmark of success. This propensity to chase returns is magnified during periods when markets are shooting the lights out, as investors become acutely aware of how their portfolio is performing relative to whatever index is attracting the most attention at the time.
Throwing caution to the wind has been very profitable – so far. But if history is any guide, there are many reasons for investors to consider taking a much more cautious stance.
Here are the facts: according to every valuation metric that matters (i.e. with statistical significance through history), stocks are quite expensive.
One of the most mind-blowing implications of portfolio theory is that a well conceived portfolio has the potential to be much better, in terms of risk adjusted performance, than what we might expect from the sum of the individual portfolio holdings.
The question of whether to commit new funds to stocks here is nuanced and complex, not least because it isn’t obvious that traditional alternatives – bonds or cash – offer any better value. We are very near all-time low interest rates across most developed government bond markets, credit spreads are near all-time tights, and rates are negative out to 5 or more years in real terms.
ReSolve Asset Management Blog is an investment research forum, opinion pieces, and educational material from the team at ReSolve Asset Management. Our views are driven by evidence based finance, with a special focus on asset allocation, factors and smart beta, retirement and endowment strategies, and quantitative methods.
