The Messenger: A sceptic’s view of portfolio construction

Intelligent investors feel more optimistic about an asset class if it can be bought more cheaply. Equally, their expectations reduce after the asset’s price has risen sharply.

No rational person should feel more drawn to an investment because it has risen recently.

Yet industry net inflow figures reflect a different picture.

During the global market bubble of 2000, net inflow into equities hit a record 92 per cent (of sector-specific funds) and the international proportion was also a record.

In the quarter to March 2003, markets indisputably offered better value yet saw a net outflow from equities.

Since then, share prices have rebounded. They must have offered better value in March than now, yet I expect that the next inflow figures will show increased inflow.

These are irrational reactions to past performance. Yet we know that the majority of investments are placed through planners, that is, ‘experts’.

Some planners have felt more optimistic in recent months, with the market’s recovery. Naturally, client reviews are more enjoyable — reporting positive returns is more fun than negative.

The corollary of this would be a further increase in optimism as markets rise still further, taking us back to the tech boom where there was euphoria just before the collapse.

How do we get off this merry-go-round?

Planners need to adopt a process of systematically valuing markets and constructing asset allocation models accordingly. However, this requires us to cease to be hypnotised by two prevailing industry mantras.

First, there is the factually false statement that, “The stock market always produces sound/superior returns in the long run”. This is not a matter of opinion but historical fact and it depends on the definition of ‘long run’. Over 30-year periods it is true.

However, the S&P 500 produced negative real total returns over 10-year periods starting in each of December 1908, June 1911, August 1929, March 1937, September 1964, November 1968 and July 1972.

The Nikkei is down materially over 14 years.

The MSCI Accumulation Index lost 1.5 per cent per annum over the five years to August 2003 while bank bills delivered a profit of 5.2 per cent per annum.

The Listed Property Trust Accumulation Index has outperformed the All Ordinaries Accumulation Index over each of the last five, 10 and 20 years.

Unless ‘long-term’ is defined as three decades or longer, a statement that the stock market always produces a good return in the long run is misleading.

A very practical definition of the ‘long-term’ is the period that clients will accept poor returns before they will sever their planner relationship. This will vary for individuals. Many will display patience for two or three years. Not many would do so for five years.

The second false truism is that “it’s time in, not timing, the market”. I define timing as investing in the belief that one can know the direction of a market in the short-term, up to say two or three years. I believe this is impossible.

It is possible, with a reasonable degree of confidence, to determine the direction of markets over longer periods than this. What basis is there for this?

The essence of any sound strategy is to have a reliable method for determining whether a market offers good or poor value. Poor value may not be corrected in the short-term, but after several years it is highly likely to be. Equally, good value is likely to produce strong medium-term results.

The next section of this article will analyse valuations using the S&P 500, as the US market has data available for 120 years.

The graph shows theCentrestoneValuation Summary which incorporates these methodologies. The grey line represents the market’s value fluctuating around its average. The further above the mid point the line is, the more the market is overvalued and vice versa.

The black line represents the real total return over the subsequent seven years. It also fluctuates around this average, that is, above the mid point, represents an above average return and vice versa.

The two lines represent a rough mirror image of each other, that is, overvalued markets were correlated with poor subsequent returns.

The table (right) analyses the results of this method.

Taking the 10 per cent of times when the market was most overvalued, the median subsequent real return was 2.0 per cent per annum. The second highest 10 per cent produced 3.9 per cent per annum.

At the other end of the spectrum, the 10 per cent of best value opportunities produced a median real return of 15.2 per cent per annum.

The method is very useful at both market extremes. In the middle ranges, the outcome is much more random for reasons I won’t go into here.

Should this impact asset allocation? If a market is in a value range where, historically, median real returns have been 2.0 per cent per annum, would you want the same exposure as at a period when they were 15.2 per cent per annum?

What is the current market valuation? At September 19, the S&P was 1,036. According to the Centrestone valuation method it would need to fall 33 per cent to reach its median value. It sits in the 10 per cent worst value band, which has averaged 2 per cent per annum real over seven years.

Adding the current rate of American inflation produces a prospective return less than Australian cash. Make what you want of these figures in deciding the relative attractiveness of these asset classes. However, if planners are now telling clients that markets have fallen so recovery must be imminent, or the recent bounce back is a new bull market, I suggest that we may again be forgetting to value the market.

In 2000 our industry largely failed to notice that most proven valuation methods indicated that the world’s largest market was more ridiculously overpriced than at any time in its history.

Was your research supplier warning you? How valuable is our industry’s research if it fails to notice such an event?

Many planners acknow-ledge that asset allocation is not their core skill and are looking to outsource it. Before choosing a provider, find out if they noted the excesses of the tech boom.

Like history repeating itself, I find myself again urging an unpopular caution. This is not a timing call, simply a statement about valuation.

There are differences from 2000 in that not all international markets seem equally overvalued, which will be of little value to an index fund, or a closet indexer (most of the rest) with their high USA exposure.

Most planners have been trained to unfailingly adopt a 70 per cent “growth” asset exposure and to live with downturns.

What we saw in the equity boom was simply a failure to diversify. Many advisers feel a constitutional aversion to investing more heavily in “boring” interest-based investments. Yet anyone who adopted broadly diversified portfolios at the peak of the tech boom, with say, 30-40 per cent in equities, has had little difficulty producing positive returns over the last three years.

The next quarter’s net inflow figures will make interesting reading.