An Anniversary and Some Words on Garbage

Garbage in, garbage out

This week marks the anniversary of the bull market whether you measure from the intraday bottom on 3/6/2009 or the day’s closing bottom on 3/9/2009.  It’s not as simple as all that, though.

After a 19% annualized gain or over 300% cumulative, it’s hard to ignore claims that the market is over-valued.  Sure, the doom and gloom folks have been saying that all the way up, but it’s getting harder to find statistics that don’t show the market at least fairly valued.  JP Morgan’s David Kelly shows P/Es slightly above historic averages, but the Shiller CAPE is really elevated.

Some things to keep in mind

After a long run, it feels like we are due for calamity or at least a pullback.  We’ve already had a pullback – four of them, in fact.  And we only need to look at last year to remind ourselves that the market’s rise was not always easy to digest.

If you want to get technical, the bull market is only 4 years old since a new bull begins after breaking through previous highs.  Josh Brown has more here.  Since I don’t time the market, it doesn’t really matter to me, but perma-bears live for semantics and it’s nice to be able to throw this on the table if a discussion gets into the weeds.

Returns for the last 8 years look fantastic, but 10 year returns are still below historic averages.

Market cycles peak at euphoria, over-shooting fair-value.  You will never see an extended time where the market is fairly-valued.  So maybe it’s not time to panic after all.

We will get additional pullbacks.  Credit/blame will be assigned.  None of that matters to a long-term investor with a solid plan.  The more fiddling an investor does to his/her portfolio, the lower the odds of a successful outcome.  Control what you can control.  Realize that no one controls the stock market.

Garbage In…

We seem to be at that point in the cycle where a new asset class or investment product has had a few years to gain traction in the marketplace and is sold as the fix to the problem you don’t have.  Here’s the pitch:

“Sure, the venerable 60/40 portfolio has done well in the past, but we expect low returns from equities going forward.  Couple that with low bond yields and it’s clear that most investors have unrealistic return expectations.  Luckily, we have found an asset class that has low correlation to stocks and pristine backtested returns.  This will shift the efficient frontier up and left, giving investors higher risk-adjusted returns.”

I just came across the pitch here on Advisor Perspectives.  The miracle asset classes: factors and risk parity.  I actually like the idea of factor investing (not to the extent shown in the link), but it is still a new space where money management firms are pumping out tons of factors (and combinations of factors) and selling them in the hopes that some of them stick.  A couple of gripes with the argument:

Predicting returns for any asset class is difficult to impossible (the uncouth might say bullshit).  Financial models are only as good as the data that is input.  Garbage in, garbage out.  Using the same MPT efficient market model, I can show that soybeans should make up 60% of every investor’s portfolio if I input the right expected return and volatility for soybeans.

Second, I’ve heard this pitch before.  From 2007-2010 the exact same argument was made for commodities (both individual and baskets) and hedge funds.  Low correlation.  Downside protection.  30-40 years of amazing returns.  Look how it bends the efficient frontier!  The low expected returns for traditional asset classes was the same, too.  Remember the New Normal?

Beware complicating your portfolio for the sake of complicating it.  Statistics may look great, but very few investors can cling to strict Modern Portfolio Theory when the assets that are supposed to be diversifying away risk are going down.

Photo by cristina.sanvito