In recent months, we've heard a related, but also mistaken lesson from various corners of the investment community. This one suggests that poor market returns over a 10-year period, in and of themselves, can be taken as evidence that market returns over the following decade will be glorious. The problem is that this argument fails to take valuations into account. Historically, poor 10-year periods have invariably terminated with very low valuations and very high yields. It is the low valuations that resulted in high subsequent long-term returns, not the poor preceding market returns per se.
Likewise, high unemployment rates cannot be taken, in and of themselves, as a signal that subsequent market returns will be strong. Look at the relationship between the unemployment rate and the dividend yield, and what you'll find today is that the current dividend yield is way outside of the oval. Historically, high unemployment has been associated with high subsequent returns, but only because high unemployment was associated with high stock yields and depressed valuations. Not today.
Our estimates for S&P 500 total returns remain below 5% at every horizon shorter than a decade. One can argue that 5% is "attractive" relative to less than 3% on a 10-year Treasury bond, but that assumes a static world where stocks are risk-free and securities deliver their returns smoothly. If investors decide that they are no longer ecstatic about these low prospective rates of return a year or two from now, they will promptly re-price the assets to build in higher rates of expected return. Unfortunately, the way you increase the future expected rate of return is to drop the current price, and the amount by which prices would have to drop in order to normalize expected returns is enormous.
From our standpoint, it isn't likely that investors will get their expected 5% return over the coming decade in a smooth, diagonal line. Our guess is that they will instead see a large negative return over the first two years or so, followed by subsequent returns that are much closer to the historical norm. The third alternative, of course, is the bubble scenario, where stocks achieve returns above 5% annually in the immediate few years, followed by flat or negative returns for the remainder of the decade. That is certainly the pattern we observed beginning in the late-1990's.
We'll take our evidence as it comes. As I noted at the beginning of this year, as move toward 2011, we are increasingly weighting post-1940 data in setting expectations about prospective returns and risks, in the expectation that there is a wide enough range in that data to manage the residual economic risks we observe.
Presently, we have a combination of overvalued, overbought, overbullish, rising yield conditions that have been very hostile for stocks even in post-1940 data. We also have not cleared our economic concerns sufficiently to lift that depressing factor on the expected return/risk profile for stocks. It follows that changes in some combination of those factors - valuation, overbought conditions, sentiment, and economic conditions, provided that those changes aren't accompanied by a clear deterioration in market internals - would prompt us to remove a portion of our hedges (most probably covering short calls and leaving at least an out-of-the money index put option exposure in place). Unfortunately, with stocks overvalued, a shallow decline that simply clears the overbought condition would not leave much room to advance until stocks were overbought again, so the latitude for a constructive position would be limited. Ideally, we'd prefer a very substantial improvement in valuation, that is, significant price weakness that would also be accompanied by internal deterioration. In that event, as in 2003, we would look for early divergences and internal strength as an indication to remove the short-call portion of our hedges, and possibly more depending on the status of valuations and other factors at the time.
