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.