Christmas will soon be upon us. Many of us in the investment business have just completed annual performance reviews and informed our staff of compensation decisions that are charged with practical and symbolic significance. These are bittersweet times. No doubt we all have talented people who have put in great effort but met with bad luck and worse results. Clearly, there is no lack of the opposite as well. Ah, the million dollar question in management and a topic for yet another B-school case study: “Do you reward application or outcome? Input or output?” The aftertaste in our mouth may be the eggnog, but perhaps it is the smack of our better judgment and the trace of our choice to pay big incentives for what we know was partly the product of chance. In any event, we concede that the ritual of celebrating good fortune is best observed in this time of festivity. You might have been a big winner. You might be the lucky one next year. Have some eggnog.
And there is an inescapable irony. In our quiet introspection, as we look back on this past year, we, the investment officers and research analysts of the world, are smarting from the same thing. It’s been a tough year for anyone who hasn’t boldly overweighted U.S. equities in the face of inevitable tapering, continual political dysfunction, and the uncertainty surrounding public policy. It’s been a bad year for anyone who has prudentially diversified away from a concentrated equity allocation. Nearly everything else has performed abysmally.
But let’s not dwell on the unpleasantness. Let’s take credit for what we got right. Let’s bemoan the irrationality of the market for the calls that we got wrong. And let’s look ahead to the coming market environment. A humorist said, “An economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today.”1
Forecast the Market?
Forecasting the future would merely be psychical posturing if there were no evidence for its feasibility. Fortunately, this year the Nobel Prize Foundation honored two economists who both produced works suggesting that index dividend yields and cyclically adjusted P/E ratios (CAPEs), among other aggregate variables, can predict future equity market returns. While Eugene Fama and Bob Shiller virtually anchor the opposite sides of the market efficiency debate, Shiller’s 1987 and 1988 research papers with John Campbell (1988a, b) and Fama’s paper with Ken French (1989) conclude that market valuation ratios forecast five-year returns with satisfactory accuracy. High dividend yields and low CAPEs tend to predict above-average future returns; conversely, low yields and high CAPEs signal below-average returns.
While our two Nobel Laureates may disagree on why investors might plow money into the stock market when valuation levels are already high, they do agree that high CAPEs and low dividend yields are symptomatic of investors’ higher-than-average demand for equities; this willingness to bid up prices must, at some point, result in a lower-than-average future return. The CAPE (or the Shiller CAPE, as it is often called) spectacularly forecasted the carnage of the 2000 tech bust and the 2008 Global Financial Crisis. Of course, the same indicator has often predicted bear markets many quarters ahead of any appreciable decline.
So what did the Shiller CAPE of 21 for the S&P 500 Index tell us in January 2013? Given that it had a recent trend of 22 and a long-term average of 16.5, U.S. equities appeared to be neutral to extremely overvalued. The U.S. equity market’s return of nearly 30% in 2013 has pushed the Shiller CAPE toward 25; this appears decidedly expensive relative to recent and long-term levels. For emerging market (EM) equities, the Shiller CAPE stood at 15 at the start of 2013 versus its recent trend of 20.5 and long-term average of 16; EM equities thus appeared attractive to exceptionally cheap. Their –1% performance in 2013 has been one of the big disappointments for global equity investors who expected a recovery in economic growth after the great U.S. recession.
What ought we make of the Shiller CAPE’s 2013 performance and its implied 2014 prediction? Contrary to CAPE-based expectations, U.S. equities outperformed EM equities by roughly 33%. Do we shrug off this perverse outcome as a fluke, an outlier? Should we double down for 2014 by further rebalancing away from U.S. equities toward EM stocks? It certainly feels dangerous to jump on the U.S. equity bandwagon after the 2013 rally.
Shiller CAPE Controversy
Of course, a discussion about the efficacy of the Shiller CAPE would be incomplete without considering the much ballyhooed disagreement between Professor Jeremy Siegel and Bob Shiller, himself, on the right way to compute the measure. The gist of Siegel’s argument is that backing out abnormal corporate earnings write-downs would make the Shiller CAPE look more compelling for U.S. equities. In reality, the controversy is groundless. Siegel wanted to rationalize the Shiller CAPE model’s underwhelming 2013 performance by recalibrating the model inputs so as to generate a buy signal for U.S. equities, retroactive to year end 2012. Siegel is Shiller’s dear friend and loyal champion; one might perhaps infer that he wanted the Shiller CAPE to work more than did Shiller himself.
Curiously, applying the same calibration method, we are likely to get a significantly more attractive buy signal for EM equities. This would, again, prompt a massive overweighting of EM equities at the expense of U.S. equities for much of 2014. Whether one sides with Professor Siegel or Professor Shiller, it does seem that, at the current Shiller CAPE, both would prefer EM equities over U.S. equities.
While we are on the subject of Nobel Laureates in finance, it is worth remembering the crowning insight of Professor Harry Markowitz, who won the prize in 1990: diversification is the ultimate free lunch in investing. Clearly, 2013 was not the year for Nobel-worthy investment ideas. This year was most unkind to diversification. The free lunch was nothing short of bitter. Excluding equities, most asset classes had near zero to negative returns for the year, as Table 1 illustrates.
Does 2013 tell us that diversification is no longer operative? I would hope that investors do not reject sound investment principles on the basis of outlier experiences.
Fixed Income Crushed
It was probably no surprise that fixed income performed poorly. Nominal yields have been low; naturally, therefore, realized returns were also low. What was noteworthy was the divergence in performance between TIPS and nominal Treasury bonds. The negative yields registered by TIPS were a consequence of investors’ overreaction to the inflation risk engendered by massive quantitative easing. The substantial underperformance of TIPS relative to conventional Treasuries was the expected mean-reversion in inflation expectations, or the breakeven inflation. Alas, it marks a small victory for us contrarian value investors for 2013!
All eyes are now on the policy leaning of the Yellen regime.
The Federal Reserve announced that, starting in January 2014, its monthly bond purchases would be lower by $10 billion. Tapering is officially under way. However, the announcement also stated, “The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative….” The full economic and market impact of bringing quantitative easing to a close remains to be seen.2
According to a 2013 market outlook survey recently released by CFA Institute, 71% of all respondents now believe that equities will be the best performing asset class for 2014; this compares with 54% at the end of 2012. Respondents are also most optimistic about the U.S. stock market and most pessimistic about Brazil. These views reflect the familiar extrapolation of past returns and momentum in sentiments. Whether the survey has any forecasting power is difficult to assess and is, in any case, beside the point. The U.S. equity market can certainly rally another 20% in 2014. That is entirely within the realm of possibility, even if the Shiller CAPE predicts it to be improbable. What is, however, forecastable with a great degree of assurance is that if the U.S. equity bull market continues into the first half of 2014, many investors will pour more cash into equities and fire managers who have underweighted U.S. stocks. When all is said and done, this decision is likely to prove extraordinarily costly.3
1 The quote is attributed to the great American humorist Evan Esar.
2 See Hsu (2013).
3 Goyal and Wahal (2008) find that the wealth lost by investors from the practice of firing and hiring managers on the basis of recent performance far exceeds the average net-of-cost underperformance of active management. The same finding has also been demonstrated in a number of Towers Watson research reports.