Diversification Part 2: Correlations

Yesterday I discussed the concept of diversification (what it is and what it isn’t) at a high level.

I wrote, “Diversification has very little to do with how many stocks, mutual funds and ETFs are in your portfolio. Rather, diversification is about the correlations between assets in your portfolio.”

“Correlation” may be a bit of a hazy, confusing concept for some so I’d like to provide a bit more color (literally and figuratively).

So, let’s start by taking a look at correlations between major asset classes in the matrix below. Continue reading “Diversification Part 2: Correlations”

Interesting Find…

Executive Summary

The returns on both stocks and bonds for the next ten years are likely to significantly underperform their long-term averages. However, I believe there will be a generational opportunity to buy up great assets at fire sale prices within the next 5-8 years.

We also need to be looking “outside the box” for non-traditional assets to include in portfolios that may offer more attractive risk-return profiles than traditional bonds and stocks.

Market Valuations / Shiller PE and Historical Return

Yesterday, I was updating various market metrics I follow. Came across something interesting.

First, some brief background. Shiller PE is just one of many measures of market valuations. Shiller PE is the price of the S&P 500 Index divided by the last ten years of inflation-adjusted earnings for the S&P 500 (essentially a variant of price / earnings). This ratio helps us determine if price is very high, very low or reasonable relative to underlying earnings in the context of history.

The higher the ratio the more expensive the market (and potentially lower the future returns) and vice versa.

I’ve shared the charts below previously. They show major peaks and troughs of the Shiller PE along with 10-year subsequent returns from those inflection points. The charts illustrate the relationship between high valuations and low subsequent returns as well as low valuations and high subsequent returns.

However, the data below is not that useful in real-time because (1) the Shiller PE peaks and troughs are not at consistent levels. For example, the level at peaks have ranged from 22.2 to 44.2 while the level at troughs have ranged from 4.8 to 13.3, and (2) you don’t know you’ve reached a peak or trough until well after the fact potentially causing you to sell stocks too early or too late.

shiller pe and future returns

The average Shiller PE at its important peaks is 31.1. October’s Shiller PE was 31.62. The peak PE for this cycle was set in September of 2018 at 32.6. But we know from the Dot-Com Bubble that popped in 2000 that Shiller PE has gotten to 44.2 so it’s very difficult to know if valuations have peaked yet or not.

So, then I looked throughout history to find months where Shiller PE has been between 28 – 32, or roughly at current levels. There have only been 17 such months going back to 1929. These 17 months generally encompass just three periods (1) 1929 right before the Great Depression, (2) 1997 three years before the Dot-Com Bubble burst and (3) 2001-2002 as valuations were on their way back down from the Dot-Com Bubble burst.

What we find is that the average subsequent 10-year price return of the S&P 500 has been 23.2% from those months, or just 1.3% annualized. Compare that to the average price return for all 10-year periods of 86.2%. In other words, the 10-year returns for the S&P 500 starting at months with a Shiller PE of 28-32 are only about 1/4th of their long-term average!

The annualized price returns from these periods have ranged from -9.14% to 6.72%. In other words, best case from current valuations is that U.S. stocks have matched their long-term averages from elevated valuations and worst case was a 60% loss over 10 years. That’s not a great skew.

But when we invest we don’t simply have a choice between stocks or nothing. So I compared the returns of stocks to the returns of 10-year Treasury bonds for those same 17 periods. What I found is there’s not a single instance where the price returns of the S&P 500 outperformed 10-Year Treasuries. The average 10-year Treasury yield for those 17 periods was 5.2% while the average annualized price returns of the S&P 500 was just 1.3%. So even if you add 2%-4% for dividends you have not matched the yield on 10-Year Treasuries when starting from a Shiller PE of around 30.

Currently, the 10-year Treasury yield is about 0.9%. So does that mean the S&P 500 has a better chance of outperforming this time because the hurdle is so low or are Treasury yields low because projected economic growth and inflation estimates for the next ten years are also low? It’s possible stocks may even underperform the meager 0.9% offered on Treasuries for the next ten years. Dr. John Hussman has performed extensive, in-depth valuation work that suggests the latter outcome is more likely.

“The Buffett Indicator”

The correlation of Shiller PE to subsequent 10-year returns is about 83%, which is pretty good. However, we have better metrics with higher correlations. One of those is Market Cap / GDP (or variants of that), oft-termed the “Buffett Indicator” as Warren Buffett has said this is probably the single best measure of where market valuations stand at any moment. Per Dr. John Hussman, the Buffett Indicator has about an 89% correlation with subsequent 10-year returns.

Here I have no past examples from which to draw as Market Cap / GDP has never been as high as it is today (I only have data going back to 1950). The closest it’s been previously was at the heights of the Dot-Com Bubble of 2000, and we know what happened there.

buffett indicator

Conclusion

One thing is quite clear to me, the returns on both stocks and bonds for the next ten years are likely to significantly underperform their respective long-term averages. However, I also believe there will be a generational opportunity to buy up great assets at fire sale prices within the next 5-8 years. But we also need to be looking “outside the box” for other non-traditional assets to include in portfolios that may offer more attractive risk-return profiles than traditional bonds and stocks.

Finally, these factors and expected returns must be considered when both (1) preparing financial projections, and (2) determining appropriate investment strategy.

Disclosures:

Past performance is no guarantee of future results
. All investments maintain risk of loss in addition to gain.

Data from third-parties is believed to be reliable but accuracy is not guaranteed. Much of the data used to interpret the markets and forecast returns are often at odds with each other and can result in different conclusions. Many different factors impact prices including factors not mentioned here.

This is NOT investment advice but merely a general commentary. Individualized investment advice cannot be provided until a thorough review of your unique circumstances and financial goals is completed.

I use *price* returns simply because I don’t have data for *total* returns going back as far as I need.

Views provided here are current only as of the moment of posting and are subject to change at any time without notification. Continue reading “Interesting Find…”

NOW It’s An Official Bear Market. Some Thoughts…

It’s official, the U.S. stock market has been in a bear market since it’s all-time closing high on February 19, 2020. Yesterday, the U.S. market had it’s worst day since Black Monday 1987 (market lost over 22% in a single day).

  • This is the fastest retreat to a bear market from an all-time high in history taking just 16 trading days.
  • This ends the bull market that began with the cycle low on March 9, 2009 for an eleven year run and 400% price appreciation. That run makes it both the longest and strongest bull market on record!
  • The S&P 500 is down about 27% from its 2/19/2020 all-time high as of yesterday’s close, which is a level first seen on August 7, 2017 essentially wiping out 2.5 years of appreciation.
  • The market would have to climb over 36% from yesterday’s close to get back to the all-time highs.
  • For contrast, the foreign stock market (MSCI All Cap World Index) has been in a bear market since January 26, 2018 and is only up about 60% from the March 9th, 2009 lows.

Yesterday, sentiment hit EXTREMELY low levels with CNN’s Fear Greed Index at a record low of just 1.

Continue reading “NOW It’s An Official Bear Market. Some Thoughts…”