Stock Market Outlook: Same Song, Slightly Different Arrangement by Jeffrey Knight, CFA, ColumbiaManagement
- We are as convinced as ever that equities have a significant advantage over other asset classes based on valuation.
- Managing the risk of simultaneous drawdown across asset classes requires a process to actively de-risk portfolios and a methodology for diagnosing the conditions to trigger such a step.
- To manage risk and stabilize portfolio values in case equities do not perform well, we favor non-traditional diversifiers, explicit downside hedges and a methodology for active risk reduction.
Note: Look for Jeff in the December 13 edition of Barron’s for comments on his 2015 outlook. For the pdf of this article click here.
The other day, my teenage daughter asked how my passion for music began. I described for her my first record player, a Kenner “Close ’n Play.” This aptly named device would play your chosen 45 rpm record when you closed its cover and stop playing when you opened it. I loved my Close ’n Play, and I would listen to songs like “Can’t Buy Me Love” over and over again on it. It even had a handle, so I could carry my music from one room to another, like an iPod.
Unlike an iPod though, the Close ’n Play would travel with only one song. “Can’t Buy Me Love” in the kitchen. “Can’t Buy Me Love” in the basement. In the early 1970s there was no Pandora or Spotify or Rhapsody.
Vanguard’s move into PE may change the landscape forever
As I sit down to compose an outlook for 2015, it occurs to me that since 2009, the financial markets have been more like a Close ’n Play than an iPod — low expected returns from safe assets and stocks offering the best chance of any meaningful investment gains. Just like last year and the year before.
What’s different in 2015?
As stationary as market conditions have felt lately, circumstances are always evolving. For 2015, while the essential elements of our outlook remain in place, we highlight two important changes in the market environment:
- The relative value of global equities vs. global bonds actually improved during 2014.
- Monetary policy around the globe has become desynchronized, with the U.S. Federal Reserve (the Fed) contemplating rate hikes, while the European Central Bank (ECB) and the Bank of Japan (BOJ) intensify their monetary stimulus programs.
In this article, I will detail the implications of these conditions for investment strategy. In our view, while equities will most likely continue to dominate, the complex interactions of today’s conditions elevate the role of dynamic risk management. We argue that investors will need a cross-asset surveillance methodology to detect tactical threats.
Equity hegemony in action
For several years, we have argued that equities have a significant advantage over other asset classes based on valuation. With short-term interest rates near zero and government bond yields around the world at historic lows, the comparison between stocks and bonds based on forward-looking expected returns has been very lopsided. Market returns in 2014 underscore the valuation advantage that equities offer. (Exhibit 1)
Exhibit 1: In 2014, equities outperformed bonds again
For this comparison, we use global returns to represent equities but only U.S. returns to represent bonds. This is an unfair comparison because the equity index reflects a loss of return due to currency translation effects, while the domestic bond index does not. We make the comparison to emphasize that today, a margin of safety exists in favoring stocks over bonds.
When we analyze these returns closely, we find significant evidence of this margin of safety. With respect to bonds, the Barclays Aggregate Bond Index offered a yield-to-worst of 2.5% as 2014 began. This means that investors could have expected roughly a 2.5% return for the year if bond prices had stayed constant. The fact that the index has returned more than double its promised yield reveals that bond prices have not stayed constant, they have risen. Few investors expected bond prices to rise in 2014. Therefore, bonds (represented by the Barclays Aggregate) delivered more return than expected. Global stocks, on the other hand, delivered less than expected.
Exhibit 2: Equity returns lagged the change in corporate earnings
Exhibit 2 breaks down global equity returns into the portion attributed to corporate earnings growth and the portion attributed to changes in the price/earnings (P/E) multiple (the multiple of earnings that investors have paid for equities). For 2014, returns for the MSCI All Country World Index (MSCI ACWI) lagged the change in corporate earnings for the year. The green bars below the X axis illustrate that P/E multiples actually contracted in 2014 for the first time in years.
These comparisons reveal the powerful valuation advantage that equities enjoy today. Our proxy for equities, the MSCI ACWI, outperformed our proxy for bonds, the Barclays U.S. Aggregate Bond Index, even though:
- The equity index includes substantial losses related to currency.
- The equity index faced a headwind from falling multiples.
- The bond index enjoyed an unexpected tailwind from rising bond prices.
This is what we mean by the phrase “equity hegemony.” With the relative valuation so favorable for equities, they have delivered superior returns even when a variety of influences conspired against them.
The comparison favors equities more strongly for 2015
Exhibit 3: Equity markets offer higher expected risk-adjusted returns than bonds
Exhibit 3 depicts our valuation landscape for selected global assets as 2015 begins. The graph plots the expected return vs. risk for selected assets around the world, based on Columbia Management proprietary estimates. For each asset, the expected return (proxied by yield-to-maturity for bonds and by implied cost of equity capital for stocks) is plotted against the product of volatility and correlation to world equities. By incorporating correlation, we give credit to assets that offer a diversification benefit by adjusting the asset’s volatility downward as long as it has a correlation of less than one to world stocks. We believe this adjustment helps in the direct comparison of stocks and bonds from a risk-adjusted return standpoint.
The chart also shows a “line of best fit” through all of the points, which visually represents the compensation that investors get for adding risk by increasing allocations to the assets on the right of the zero point. Today, that line is quite steep, indicating a high marginal reward to investors willing to increase portfolio volatility. For the past several years, the best-fit line has been notably steeper than its typical level. This is noteworthy, as our adjusted volatility measure, in effect, gives an advantage to bonds and should serve to flatten the line of best fit. This cross-asset analysis was key to our assessment that global equities enjoy a valuation advantage.
Exhibit 4: The steeper 2014 best-fit line suggests higher expected returns for stocks
Exhibit 4 removes all of the individual markets and simply plots our line of best fit against the same line as it stood at the beginning of 2014. This visual reveals the surprising way relative valuation has evolved over the past year. The left side of the line has dropped, indicating that the expected returns from bonds have fallen, while the right side of the line has risen, indicating an increase in expected returns for global stocks*. Amazingly, in this era of equity hegemony, the comparison has become even more favorable for equities going forward.
Monetary policies diverge
The Fed has given strong signals that economic growth in the United States has reached self-sustaining momentum and no longer needs unconventional efforts to support the expansion. The withdrawal and suspension of large-scale asset purchases was only the first step in the evolution toward policy normalization. In 2015 we expect to see a change in forward guidance and, most likely, the first interest rate increase in years.
These actions stand in stark contrast with the direction of the monetary policies of other central banks as they double down on efforts to support growth and avoid deflation. The Bank of Japan has announced its intention to increase both qualitative and quantitative easing on an enormous scale, expanding purchases of Japanese government bonds (JGBs), exchange-traded funds (ETFs) and real estate investment trusts (REITs). They intend to coordinate this with government pension investment fund purchases by shifting into riskier assets through sales of JGBs.
With evidence of deterioration on both the economic and inflation front, the European Central Bank also plans to take bolder actions. These include increased purchases of asset-backed securities and covered bonds in both the primary and secondary market, together with the long-term refinancing operations that will steer the ECB’s balance sheet higher by €1 trillion. The latest to jump on the bandwagon was the People’s Bank of China (PBOC), which cut its benchmark interest rate for the first time in over two years to support private sector investment, as targeted liquidity injections have had minimal effect on sinking economic growth.
Markets reacted very positively to the announcements from BOJ, ECB and PBOC, as the rush of liquidity from these actions will undoubtedly be felt across global markets and provide a counterbalance to tighter policy in the United States. However, this newfound asymmetry in monetary policy also creates pressure for a stronger dollar. As we detailed in our third-quarter Investment Strategy Outlook, a strong dollar can be a headwind for risk assets. We believe that markets can withstand a gradual appreciation of the U.S. dollar, but a concentrated and intense move in currency markets represents one of the key market risks for 2015.
This tension between the tailwind that global monetary policy brings to asset prices and the potential headwind of currency volatility complicates the investment strategy challenge for 2015. While valuation strongly suggests an equity-dominated portfolio strategy, a portfolio concentrated in risk assets remains vulnerable to volatility spikes, such as those we observed during early autumn 2014. As we argued in our fourth-quarter Investment Strategy Outlook, the real loser in the face of ongoing dollar strength may be diversification. With so many assets proving vulnerable to currency movements, we believe investors must expand their search for diversifiers. Non-traditional holdings in areas like liquid alternatives, alternative beta exposures** and absolute return strategies can broaden an investor’s palate for diversification.
Cross-asset market surveillance
While adding new diversifying strategies can help stabilize portfolios, we believe diversification alone may be inadequate to protect portfolio values from future drawdowns. Looking at two recent episodes of market volatility, the taper tantrum of 2013 and the September setback of 2014, we discover a troublesome commonality. During both of these events, nearly the full array of asset classes posted negative returns. (Exhibit 5)
Exhibit 5: During two recent periods of market volatility, nearly all asset classes declined in value
While these two episodes proved to be only temporary, we think they foreshadow the risk management challenge that investors face when so many market prices are connected by interventionist macro policies. If all assets can rise together, then surely they can fall together. We believe managing the risk of simultaneous drawdown across asset classes requires a willingness to actively reduce portfolio risk and a methodology for diagnosing the conditions to trigger such a step.
Over the past two years, the Global Asset Allocation team at Columbia Management has conducted significant research on precisely this challenge. We have concluded that effective risk analysis requires a cross-asset perspective. By cross-asset, we mean that bond market conditions can be very influential to our equity market outlook, and vice versa. A methodology for simultaneously analyzing market conditions across asset classes can bring meaningful insights to discern favorable from unfavorable market conditions.
The Columbia Adaptive Risk Allocation (CARA) process offers such a methodology. This approach combines logical diagnoses of bond and stock market conditions. By design, the approach is agnostic on market conditions most of the time, as we base our analysis on thresholds of unusualness. In the case of bonds, unusualness is triggered when government bond yields become too low***. In the case of equities, unusualness is triggered by a combination of low realized volatility, favorable price momentum and reasonable valuation. These thresholds create four unique combinations of market state as depicted in Exhibit 6.
Exhibit 6: The Columbia Adaptive Risk Allocation process simultaneously analyzes conditions across assets
Our research reveals important insights from using these market thresholds in combination. For example, when equities satisfy their exceptionally good criteria, they deliver more efficient performance. However, they become a negative influence on bond returns if bond yields are too low. When equities are not in this sweet spot, downside risk management becomes more important. And if bond yields are high enough, this can be accomplished through risk-balanced investing. On the other hand, if bond yields are too low, then not only is their diversifying power weakened, but they might be signaling greater headwinds for the economy. For example, our research finds that when bond yields are too low and equity market conditions are not exceptionally good, the probability of a recession is significantly higher. In other words, the bond market can tell us that risks for equities have risen. Under such circumstances, active de-risking makes sense, and capital preservation becomes a priority.
During 2014, this methodology produced useful results. Exhibit 7 shows the month-by-month market state classification. Notice that as yields fell and equity volatility rose through the summer, our framework recognized that market risks were rising, culminating in a capital preservation market state for September. While no approach to market forecasting can capture every nuance of prevailing market conditions, we think this simple approach can help to identify the very thing that our investment strategy requires for today’s markets — a prudent and timely indication for when to reduce portfolio risk.
Exhibit 7: The Columbia Management model helps determine when to reduce portfolio risk
Investment strategy for 2015
We are as convinced as ever that relative value favors stocks over bonds, even though stocks outperformed in 2014. Therefore, like a child with a Close ’n Play, you will hear the same recommendation from us for 2015. Equities remain the most important asset class for generating returns. Within equities, the currency-based advantage of U.S. stocks is offset somewhat by the valuation advantage from overseas equities, notably in Japan. Indeed, economic growth in Japan and Europe are essential ingredients for equities to continue to perform well. If Japanese and European stocks cannot produce gains, then the global economy will probably be stuck in a near recessionary funk.
Devising a strategy to manage risk and stabilize portfolio values in the event that equities do not perform well remains complicated. Bond yields are low enough that they are not likely to offer powerful diversification benefits. We affirm our recommendation for three additional sources of portfolio stability:
- Non-traditional diversifiers, such as liquid alternatives, alternative beta exposures and absolute return strategies
- Explicit downside hedges, such as put options (with emphasis on managing the related expense)
- Flexibility and a methodology for active risk reduction when appropriate (Our cross-asset methodologies should prove valuable in this regard.)
How many times can we play the same song before we must change the record? Our overall stance for investment strategy is likely to remain in place until the valuation advantage for equities has been priced away, or until the healing process for the global economy reverses.
*The steepening of the line also results in part from the drop in equity volatility experienced over the past 36 months.
**For more information, see “Using Alternative Betas in the Management of Investment Portfolios” within our Annual Perspectives.
***Our technical definition of “too low” includes a comparison of bond yields to prevailing inflation, as well as a measure of the yield curve slope.
The Barclays U.S. Aggregate Bond Index is a market value-weighted index that tracks the daily price, coupon, pay-downs, and total return performance of fixed-rate, publicly placed, dollar-denominated, and non-convertible investment grade debt issues with at least a $250 million par amount outstanding and at least one year to final maturity.
The MSCI All Country World Index (ACWI) is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global developed and emerging markets.
Past performance does not guarantee future results.
It is not possible to invest directly in an index.
Diversification does not assure a profit or protect against loss.