Portfolios in Wonderland & The Weird Portfolio

Portfolios in Wonderland & The Weird Portfolio




by Corey Hoffstein, Newfound Research

  • The current outlook for stocks, bonds, and traditionally allocated portfolios is near all-time historical low levels.
  • Even though short-term performance may vary, investors looking for long-term success may have to expand their investment palette to earn returns anywhere close to those realized in the past.
  • A mean-variance optimal portfolio using the current market forecasts relies heavily on more unique asset classes such as U.S. Small Caps, Emerging Market Debt (Local Currency), and Levered Loans.
  • While investors may not be willing to hold such a weird looking “60/40” portfolio, thinking outside the box may be necessary going forward.

Note: After recent podcasts with Meb Faber and Jeremy Schwartz, we received a large number of requests for our “Portfolios in Wonderland” presentation and the “weird” portfolio I discussed that was a result of the current market environment.  We thought we would take the content within the presentation and make it available as a commentary.

Portfolios in Wonderland

“Begin at the beginning,” the King said, very gravely, “and go on till you come to the end: then stop.”

At the beginning of each year, many institutions publish their capital market assumptions, providing an outlook for expected returns, volatilities, and correlations.  These glossy brochures go well beyond data, however, and often veer wildly into what we like to call macro tourism: data-based market prognostications about macro-economic conditions and their implications for markets.

Unfortunately, for most investors, while macro tourism makes for an entertaining read, the track record of most predictors is quite poor.  Simply put, markets do not behave in the linear, domino-like fashion that most predictions are laid out as.  There are simply too many non-linear relationships to make accurate predictions; it is like trying to predict the exact weather in Boston a year out.

That said, if we are willing to restrain ourselves, meaningful forecasts can be made.  We may not be able to predict the exact weather, but there is a good chance the temperature will be between 65℉ and 80℉.

While exact predictions may be futile, evidence suggests that by taking a long-term view (7-10 years) and focusing on stable variables, we can make similar long-term forecasts for most major asset classes.  For U.S. investors, simply getting an understanding of what will likely happen with U.S. stocks and bonds can provide a tremendous amount of insight for the rest of our financial plan.

So, let’s begin with U.S. equities.  Here, we turn to the Shiller CAPE.  For those not familiar yet with this metric, it is a 10-year smoothed price-to-earnings measure for the U.S. equity market.  The aim of smoothing over 10-year periods is to get a measure that is less sensitive to market cycles, creating a “cyclically-adjusted” P/E (“CAPE”).

We can see that today’s CAPE is highly elevated compared to past measures.

The implication of a high CAPE reading is that stocks are expensive: you are paying more per unit of fundamental value.

In our piece Anatomy of a Bull Market, and the subsequent follow-up, we demonstrated that over the long-run, valuation changes have contributed little to U.S. equity performance.  While they can vary wildly in the short-run, they have historically exhibited mean-reverting behavior: cheap tends to get more expensive, and expensive tends to get cheaper.

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