What Can The Triple Crown Teach Us About Investing? by Jeffrey Knight, Columbia Threadneedle Investments
- In horse racing, as in investing, being right is less rewarding if one’s prediction is already reflected in the price.
- The era of easy money engineered by central banks has succeeded in flattering asset prices, but it is very difficult to identify any assets that are out of favor and inexpensively priced.
- While we still see the prospect of ongoing positive return, the payoff from here is likely to be underwhelming.
In early June American Pharaoh galloped to victory in the Belmont Stakes, winning horse racing’s Triple Crown. Since 1979, 12 different horses entered the Belmont Stakes having won the first two legs, but none went on to win the Triple Crown. From this history, one might conclude that the probability of winning all three races is not terribly high, yet American Pharaoh ran the Belmont Stakes with bettors assigning him a 63% probability of winning. Accordingly, for those willing to bet $2, the payoff was $3.50 (the $2 original stake plus $1.50 in profit). By comparison, the payoff for taking the third-place finisher, Keen Ice, to “show” (i.e., finish in any of the top three spots) was $4.60. The bet with three chances to win returned more than the bet to win outright because the expectation of American Pharaoh’s win was firmly priced into the pari-mutuel odds. In horse racing, as in investing, being right is less rewarding if one’s prediction is already reflected in the price. This analogy is important to investment strategy as we look to the second half of 2015. When we survey world financial markets today, we see lots of American Pharaohs, but very few Keen Ices.
Consider equities. Since 2009, global equities have gained more than 150%. Exhibit 1 shows the 12-month rolling price returns of the MSCI All Country World Index (ACWI) broken down by change in earnings expectations and change in valuation. We see that early in the post-crisis period, returns for global equities were driven by fundamental corporate improvement resulting in a pronounced earnings recovery. Since about 2012, though, returns have been driven by changes in valuation, meaning that the overall market index has become gradually more expensive per unit of underlying earnings.
Exhibit 1: 12-month MSCI All Country World Index (ACWI) returns with changes in earnings expectations and valuations
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Source: Columbia Management Investment Advisers, 07/15
Focusing on U.S. equities, the S&P 500 has more than tripled since the lows of 2009 and has now survived 44 months without experiencing a drawdown of 10%. Like global equities overall, recent gains have been driven by valuation changes rather than fundamental improvement. Unlike some past episodes, the valuation phenomenon is not being driven by a select subset of glamor stocks. Instead, the increase in valuation has encompassed the majority of individual stocks, as can be seen by examining the time series of the median P/E ratio across the S&P 500 constituents (Exhibit 2). By this measure, the median stock in the S&P 500 is more expensive today than when equities peaked before the financial crisis. Ample worldwide liquidity has propelled asset prices higher in a broad and deep way.
Exhibit 2: S&P 500 Index and S&P 500 Index median price-earnings ratio
Source: Ned Davis Research, 07/15
In fixed income, too, valuations are not terribly attractive. Investors instinctively recognize that with yields this low the prospect for high returns from bonds is muted. However, we do note that recent weakness across global government bond markets has at least alleviated short-term extreme pressure from overall valuation. Credit spreads have re-priced somewhat, but can hardly be considered an out-of-favor asset class available at bargain levels. So overall, we find that the era of easy money engineered by the world’s central banks has succeeded in flattering asset prices of all kinds. The dark side of that phenomenon, though, is that it is unusually difficult today to identify any assets that are out of favor and inexpensively priced.
While we still see the prospect of ongoing positive return, as with American Pharaoh, the payoff from here is likely to be underwhelming even in positive scenarios. Also, if the rising tide has been caused by easy monetary policy and falling bond yields, then recent increases in bond yields and the approach of the Fed’s first interest rate hike must surely be regarded as threats to the benign environment of escalating asset prices. The connections across asset classes seem stronger than usual, and the stinginess of Q2 returns across nearly all asset classes suggests that diversification alone may not suffice to stabilize portfolios. As a result, we are raising our allocation to cash for the first time in years from a maximum underweight to neutral. We continue to expect positive performance from equities and many categories of fixed income. However, with valuations as demanding as they have become, we recognize that most other investors expect the same. The payoff for positioning with the consensus will likely be more subdued going forward.