Too Far, Too Fast?

By Rob Arnott

JULY 2009 Read Time: 10 min

The tremendous comeback in financial assets that began in March and extended through the second quarter of 2009 has proved a welcome relief to investors of all types, a blessed batch of showers for our drought-ridden portfolios. The classic 60/40 stock (S&P 500 Index) and bond (BarCap Aggregate) mix advanced 10.2%, experiencing its third best quarter since 1988. As we predicted coming into 2009, in a broadly diversified GTAA context, some of the most dislocated credit categories from last fall—high-yield, emerging market bonds, convertibles, and bank loans— were some of the biggest winners in the first six months of 2009 as all four dramatically outperformed mainstream stocks and bonds.

Undoubtedly, most portfolios are still well underwater (60/40 is still down 21% from its October 2007 high) and likely have many years of catch up. But the respite has allowed investors to assess their portfolios and begin to make asset allocation decisions with an eye toward the future. A thorough exercise of asset class valuations reveals that many once beleaguered asset classes may have come too far, too fast in this recent rally. Accordingly, now is likely a time to take profits and to resume our cautious vigilance of 2008.

Stage 5 of Recent Markets—The “ABT” Comeback
In one of our favorite graphics, Figure 1 illustrates the benefits and opportunities of a widely diversified GTAA program. Last year saw three distinct asset allocation stages: (1) the traditional equity bear market [Jan through August], (2) the take-no-prisoners free fall [September and October], and (3) sorting through the carnage [November and December]. The first and last periods witnessed opportunities to add value through active asset allocation as roughly half the asset classes were positive despite moderate losses in the equity market. There was no such luxury in September and October—every asset class was down!

The first two months of 2009 bore an eerily similar pattern to the second stage of 2008: straight down. With nowhere to hide, the equally weighted portfolio fell 8.3%. Only three asset classes were in the black. The last four months, however, have been a welcome—and polar—opposite with 15 of 16 asset classes posting gains. Only long Treasuries lagged in the market rebound, confirming our call in Barron’s in late December that 2009 was likely to be an ABT (“Anything But Treasuries”) market.1

The figure illustrates an important point about the relative performance of the more diversified 16 asset class portfolio compared to more normal 60/40 mix. The equally weighted 16 asset class portfolio outperforms in four of the five stages, trailing only in the September/October panic. We’ve seen this before: diversification will occasionally disappoint in crisis episodes as investors tend to flee niche markets— TIPS, emerging market bonds, convertibles, etc.—en masse, swapping these for more liquid “safe havens.” But, did diversification “fail” in this take-no-prisoners market crash? Or did diversification help us with a lag?

As we noted in January, whenever diversification “failed” to deliver in the past, it more than made up for the underperformance in the subsequent recovery. This trend appears to be holding once again, with the equally weighted 16 asset portfolio delivering 240 bps over the 60/40 mix in the rebound of the last four months, and by a whopping 800+ bps since diversification “failed” last September and October. Since the financial crisis started in July 2007, diversification as measured by the 16 asset class mix has delivered measurably better results than traditionally structured portfolios with a cumulative loss of –10.7% versus –18.4% for 60/40, a premium of almost 800 bps.

This impressive advantage could have been widened further by tactically managing the asset mix to move into dislocated markets presenting the greatest opportunities. In the fall, equities experienced a “four-sigma event,” but many assets, especially high-quality alternative bond categories, experienced “eight-sigma” sell-offs. Emerging market bonds, convertible bonds, high-yield, and TIPS all reached yield levels indicative of a Great Depression, while equity prices only reflected a recession (albeit a nasty one). This appeared a relatively easy “heads you win and tails you don’t lose” decision. If a Great Depression did occur, bonds would hold up while stocks would sell off. If we averted a depression but found a severe and lasting recession, bonds would rally but stocks, already priced on such a scenario, would remain roughly flat. As 2009 has brought more “r” word references than “d” word references, these higher quality alternative bonds have far outpaced stocks as shown in Table 1. Though, to look at the economic data, we marvel at the “d” word vanishing from the scene, when the “green shoots” repeatedly appear to be weeds.

Careful What You Wish For

This lock-step rebound across asset classes has been wonderful. A 16–19% bounce from market lows in late February/early March is an ample reward for those disciplined enough to rebalance to their long-term portfolio targets and an even better bonus for those that tactically shifted into the most distressed areas of the capital markets. But now is not the time to be complacent. Most assets are no longer the bargains they were a few short months ago. As we have stated many times, tactical asset allocation is about taking risks when they are compensated and backing away when they are not. In some cases, the snapback has led risky asset classes like equities and high yield bonds to be susceptible to further price declines.

A handy, simple metric for the valuation of the overall equity market is today’s price divided by the last 10 years of earnings. Developed by Robert Shiller of Irrational Exhuberance fame, this methodology smoothes the cyclical effect of wild swings in shorter term earnings to produce a more stable measure for historical comparison purposes. What does it reveal about today’s prices? In short, despite all of the pain of the past two years (previous four months excluded), we stand very near the historical average valuation level. As Figure 2 shows, the “Shiller P/E” of 15.8 at mid-year, up from its low of 11.8 in March, is approaching the long-term historical average of 16.4.

Mohamed El-Erian and Bill Gross at PIMCO have done an excellent job of spelling out the many uncertainties confronting today’s investors as we journey to a “new normal”—re-regulation, de-globalization, and de-leveraging.2 Given these headwinds, we find it hard to become enthusiastic about “average” market valuations.

A similar story can be found in high-yield bonds that have enjoyed a massive comeback in 2009. On a total return basis, junk bonds, as measured by the BarCap High Yield Index, now stand at only 6% off of their May 2007 peak. As seen in Figure 3, the spread over five-year Treasuries is now 9.9%, almost half of what it was at the end of November.3 This spread level is equivalent to the peak spreads of the milder recessions of 1990 and 2001; but, it’s also comparable to the average spread during the Great Depression. Spread levels, equivalent to recessionary peaks rather than the unprecedented peaks of a few months ago, indicate that fear has abruptly and aggressively eased. Buyer beware at these prices, unless you believe that economic recovery is at hand (we don’t!).

The massive price dislocations of last fall provided significant opportunity for a quantitative, model-driven GTAA process to add value by scooping up high-quality assets that were being liquidated at wholesale prices and provided ample risk premiums for just about any economic scenario short of Armageddon. The window did not stay open for very long and was considerably shorter than the decision-making process for large institutions, providing a further rationale for tactical carve-outs in pension and endowment portfolios.

Alas, this target rich environment is already fast becoming a thing of the past. The same process that moved into risk last fall is pointing to lower risk exposure after this blessed rally. A capital market system adjusting to a new world of “fair” risk premiums is not the environment to assume additional hefty gains from risky assets trading at average valuations.

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1. Lawrence Strauss. (2008). "How to Play a 'Take-No-Prisoners' Market." Barron’s (December 22): 36.
2. See "Beware of the 'Business as Usual' Mindset," PIMCO Viewpoints, June 2009.
3. The spreads in Figure 3 are calculated as the yield to worst on the Merrill Lynch High Yield Master II less the yield on the five-year Treasury bond. Data is from Bloomberg.