Interactive Investor

No time for complacency

6th July 2015 10:23

Lance Roberts from ii contributor

For investors, it is not time to become complacent or dismissive of market action. While recent price declines have not violated or changed the current bullish trajectory of the market, it does not mean that such will not eventually become the case. The markets, much like a ball thrown in the air, have been lofted higher due to an enormous amount of "force" that was created though liquidity interventions, suppressed corporate profitability, pent-up investor demand, and a variety of other factors following the financial crisis.

However, when that "force" is exhausted the ball will eventually return to earth. The markets, like anything, adheres to the laws of physics. The gravitational pull of the longer-term moving average will eventually drag prices into a mean reverting event. At that point, the issue of valuations, price extensions, and a variety of other factors will become vividly apparent. Unfortunately, for most it will be far to late to be proactive which will lead to a replication of the "buy high / sell low" process that has destroyed investor capital repeatedly in the past.

Speaking of valuations. Nan Lu and I did some work recently on valuations and forward total (dividend reinvested) real (inflation adjusted) returns over long periods of time.

I have discussed the importance of valuations and forward return expectations in the past (see here) but John's commentary is very important because it highlights a huge disconnect between what individual individuals THINK and how they ACT. Specifically, individuals believe they are truly "long term" investors and that they will make investments for very long periods of times (10years or more.)

However, as shown by repeated studies, that belief is confounded by the fact that individuals react to short-term market volatility and other inputs which leads to emotional decision making. Of course, the media/press/blog community is primarily to blame for these actions by focusing a spotlight on each data point within the financial markets rather than helping investors focus on the "long game."

One of the more useless discussions as of late has been on the irrelevance of high valuations as it relates to market returns of the next 12 months. To wit:

"The so-called CAPE, popularised by Professor Shiller of Yale is extended but unfortunately has no ability to predict stock price outcomes a year later," Citi's Tobias Levkovich said on Friday. "Yet, that does not seem to confound the bears, which we find both intriguing and revealing about motive rather than study."

The problem is what I have addressed in the past as a "duration mismatch." Shiller's CAPE ratio is not about what happens in the next year but rather what returns investors should expect over the next 10 or 20 years. After all, we are saving and investing for our retirement, right?

The following two charts show the TOTAL (dividend reinvested) REAL (inflation adjusted) forward returns from every level of CAPE since 1900. I have noted with the red box the current range of CAPE.

The good news is that forward returns over the next decade or two have IMPROVED from the low levels witnessed at the turn of the century. The bad news is that forward returns are likely to be PRIMARILY a function of inflation and dividends more than capital appreciation. Unfortunately, most investors will do far worse.

It is time to pay close attention to market dynamics and adjust portfolio risk exposure accordingly. While I don't know WHEN the next major market reversion will occur, I do know that it eventually WILL. This is why managing portfolio risk and paying attention to the overall trend of the market will allow for a more logical decision-making process rather than reacting to headlines.

It is always better to be more conservative during periods of market uncertainty as it is much easier to increase portfolio "risk" when the overall environment gains clarity. However, spending long periods of time making up losses is much more problematic in achieving long-term investment goals.

Deterioration Everywhere

Over the last several months every primary indicator of internal market strength has deteriorated. From relative strength to price action to momentum, the market is showing signs of exhaustion that have only previously been witnessed at more important cyclical market peaks.

The WEEKLY chart below shows this deterioration rather clearly.

With relative strength deteriorating, momentum and moving averages all on the decline, the risk of lower market prices has risen markedly as of late.

HOWEVER, while the internals are VERY weak, the bullish trend has not been violated as of yet. This keeps portfolios weighted towards equities momentarily as liquidity flows into the market are still support asset prices. It is important to note that despite the internal deterioration currently, the markets still rest near all-time highs.

If you look back at the previous two market peaks there was a lag of 10 to 12 months before the markets were unable to ignore the underlying deterioration. This is likely the case today and as Justin Kermond recently noted in his discussion of Jeremy Grantham:

Grantham said that the market is driven by career risk where investors' job descriptions are to keep their jobs. They do this in the stock market by following Maynard Keynes advice: "never be wrong on your own" and "if you are going to be wrong, make sure you have plenty of company." This process guarantees that investors herd together and drive asset class valuations way beyond fair value.

Based on regression to the mean, GMOs seven-year forecast assumes valuations will normalize over a seven-year time horizon, with both lowered profit and P/E levels. Grantham forecasted a -2.3% seven-year return for US large-cap stocks. Over that period, the earnings growth will revert to 5.7% real annually.

Grantham challenged the Fama-French market efficiency theory. Grantham and his GMO team have identified and studied 28 important investment bubbles that all "broke completely." He defined a bubble as a two-sigma (or two standard deviations above its historical mean) event. Each historical bubble that was two standard deviations above its mean reverted to the mean six months faster on average than they rose. In 28 of 28 cases, two-sigma events were highly predictable and lead to collapses, he said.

Although we currently have many of the necessary bubble conditions - including overpriced equity, bond and fine arts markets - Grantham said there needs to be a trigger to break the bubble. There are no "institutional pessimists," he said, and there will be no trigger until individuals pour into the market. He said, "We need to wait until deals become more frenzied and individuals become crazy buyers."

He does not see a Fed rate hike as the trigger. He forewarned the audience, "You have to wait for the trigger so be brave." Grantham said the moral hazard of the Fed-driven economy is that in a bull market you are on your own, but in a bear market the Fed will immediately come to help. This makes for long seven-year bull markets followed by 18-month declines. Grantham thinks this provides further support for the stock-option culture where "options rise, you make a fortune, they crash and you rewrite the options."

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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