posted on February 09, 2016 16:03
Most probably weren’t predicting a flat to negative year for both bonds and stocks, resulting in portfolios ending the year with little to no change. Historically, such years have been almost non-existent. So what do we think going forward? Here, we step through four short-term themes and then approach the long term by illustrating our framework of forward-looking (20-year) return estimates by asset class.
Short-Term 4 E's
- Easy:Having been in an accommodative (easy money) mode since 2007, the U.S. Federal Reserve (Fed) began a new era of monetary policy on December 16, 2015 and made its first short-term rate increase of 0.25%. The Fed is likely to continue to make small upward moves over the next several years, trying to balance modest inflation and full employment. The rest of the developed world, such as countries controlled by the European Central Bank and Bank of Japan, will likely pursue additional quantitative easing and are well behind the U.S. in terms of raising rates.
- Energy: We all want more energy in life, but having too much energy supply (specifically oil) in the commodity world has not been favorable to markets. Looking forward, the supply and demand for oil should begin to even out in 2016 if the anticipated lower production and higher demand begin to equalize. Stress in the energy sector will be present in 2016, but there is no strong evidence that it will spread to healthier sectors. On a positive note, lower energy prices will continue to provide a boost (similar to a tax cut) to consumers and other users.
- Emerging:China, and its impact on the rest of the emerging world, will continue to be a focus in 2016 as markets react to their ability to engineer a more sustainable growth rate, stabilize its over-built housing and slowing manufacturing sectors, and continue to transform from a manufacturing to a consumer-based economy. Should there be further strengthening of the U.S. dollar and depressed commodity prices in 2016, emerging markets and their currencies will continue to face headwinds. The good news is that emerging market stocks are among the lowest priced asset classes so they could perform well.
- Elections: The 2016 presidential election will take center stage. Historically, elections are in large part determined by how the economy and markets perform during an election year. Of course, both political parties claim to have all the answers. Evidence suggests that governmental policy has had little effect on long-term historical stock returns. However, that does not mean that certain election tactics could not cause volatility in the short term.
- Stocks: With U.S. stocks being fairly valued (based on price/earnings and price/book ratios) and low expected inflation of 2.0-2.5%, long-term U.S. stock returns are expected to be lower than historical returns. A closer look at value stocks reveals that expected return premium has not been realized in recent years. The next article, “What About That Value Premium?” illustrates some evidence of an underlying expected premium. Developed international stocks have moderately higher expected returns than those in the U.S. due to lower valuations. Emerging market stocks have even lower valuations relative to history and are expected to produce returns above those in the developed world in the long term.
- Bonds: The U.S. likely just ended a 25-year bond bull market of falling interest rates. Rates are low today and will likely move up slowly over time. Starting with such low yields today puts our expected returns for bonds in the low single digits. Outside the U.S., central banks in developed countries such as Europe and Japan are still in an accommodative stance, resulting in even lower starting yields. Thus, expected returns for those bonds are lower in aggregate.
- Alternatives: The expected returns for alternatives are in the range of 6% for all three asset classes. Global REITs, commodities, and managed futures share low to negative correlations with traditional asset classes and can potentially give portfolios better risk-adjusted returns over time.
What About That Value Premium?
While we believe that markets are highly efficient and should fairly price assets over long periods of time, the market is made up of real people with real emotions – leading to under- or overreactions. This human nature highlights the need to remain diversified. As difficult as it may seem to predict the direction of the market as a whole, it is even more difficult to predict the direction of individual asset classes. As we know, remaining diversified reduces the risk in a portfolio and allows investors to enjoy the upside when any asset classes are outperforming the rest of the market.
Empirical evidence points to a historical premium for investing in value stocks. As such, Savant optimizes portfolios with a tilt toward value stocks globally. Although slightly more volatile, from 1/1/1928 through 9/30/2015 value stocks provided an additional 1.4% (as measured by the Fama-French U.S. Large Value Index) in return annually relative to the S&P 500 Index. That compounds to an additional 71% of return over an investment lifetime of 40 years! As short-term traders react and the market ebbs and flows, it is difficult to realize this value premium in the short term. Patient, long-term investors can reap these benefits when the market favors value by maintaining a strategic allocation to value stocks.
It is difficult to remain disciplined following periods when growth stocks outperform value, but it is impossible to determine exactly when the tide will turn. Valuations, however, may give us a hint. Valuations convey how cheap or expensive individual stocks are relative to their historical prices or other stocks. One such valuation measure is Book-to-Market (B/M), or the book value of a company’s assets divided by the current market price of its
stock. A higher B/M ratio indicates the market is placing a lower value on the company’s assets – in other words, it suggests that the company is less expensive. Combining this data for every company within a given asset class allows us to draw comparisons between value stocks and other asset classes.
Using figures provided by Kenneth French back to 1945, the historical average B/M ratio of U.S. large value stocks is 14.1 versus a B/M ratio of 6.4 for U.S. large core stocks. To facilitate the comparison of these asset classes, a ratio of two historical numbers is calculated and shows that the U.S. large value B/M is on average 2.2 times that of the U.S. large core B/M. This ratio has recently crept above 2.5 as of 11/30/15, signaling that U.S. large value has become undervalued. The amount of undervaluation is calculated using the percentage change from 2.2 to 2.5, or 13.6%. Historically, as shown in the exhibit below, when value stocks become noticeably less expensive than core stocks, a value premium is often realized in the subsequent 10-year period. In fact, Savant’s current forward-looking returns project U.S. large value to have a significant premium relative to U.S. large core over the next 20 years. The data implies that disciplined investors, in a diversified portfolio with a tilt towards value, are likely to receive a value premium in the coming years.