Asset Allocator: August 2015- Viewing the Fundamentals

In his latest Asset Allocator post, David Stevenson looks into the value of economic forecasting when considering where to place investments. David reviews a number of key fundamentals such as Robert Shiller's CAPE (cyclically adjusted price to earnings ratio). David uses the measure to examine the prospects for the UK, United States and other key markets such as China and Japan.

 The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only.

 Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment.

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ASSET ALLOCATOR: August 2015 

17/08/15- Viewing the Fundamentals

 

Obviously we’d all love to know to know what will happen in the future, wouldn't we? If I had a magical crystal ball that allowed me to see into the investment future I think I can with some certainty suggest that I wouldn’t be sharing any insights with the dear reader - I’d be running the world’s most successful hedge fund and be as rich as Croesus! Obviously there are a few obvious flaws to any such plan, not least that frankly no-one knows anything about the future, except that it is likely to be unusually uncertain! But nevertheless investors do need some measure against which to measure the possibility/probability of future returns. This ‘yardstick’ is nothing more than a guesstimate but it is useful nevertheless. One key use of this forward looking planning framework is that allows the investor to sensibly judge how much money they need to put aside for the future. If one assumes real total returns of say 1% (that is returns above inflation of 1% per annum) then you’ll almost certainly need to put aside a heck of a lot more money than if you believe future real growth rates will be closer to say 5% per annum. 

All of this crystal ball gazing needs to be taken with a huge pinch of salt of course but it’s not an entirely fruitless exercise, largely because valuations over the long term do actually ‘matter’. Put simply a financial asset that is already expensive using fundamental measures such as the price to earnings ratio is highly unlikely to produce a stellar return when compared to a financial asset that is cheap. 

And if one accepts that fundamental measures of value have some relevance, perhaps the strongest long term measure of value is something called the cyclically adjusted price to earnings ratio or CAPE. Also called the Shiller P/E ratio this ratio was popularised by academic economist Robert Shiller, as a valuation metric that divides real prices by an average of real EPS over the prior 10 years. This approach allows the price-to-earnings relationship to be viewed in the context of multiple business cycles and is not biased by the most recent events. The CAPE measure is valuable because it allows a market/share and its current valuation to be viewed against its historical context. Very simply as this multiple stretches beyond the average, reversion is expected to occur. Many academics and investment managers have looked long and hard at this CAPE measure and something approaching a consensus has emerged – in the short term, as a guide to what might happen with day to day markets it’s next to useless but over the long term of many years, the CAPE measure has significant predictive power based on past returns. 

Obviously an important caveat is in order, which is that maybe in the future the relationships that power the CAPE might break down. Over the past decade for instance critics have rightly pointed out that the measure has been skewed by including depressed earnings from the financial crisis. Other critics have – in my view tellingly – worried that the CAPE measure might decline in potency in a global system where interest rates are abnormally low, perhaps allowing stocks to become much more expensive than normal and then stay that way? 

Nevertheless I still think the CAPE measure is useful as a guide or a pointer towards future returns. It’s not full proof and it certainly shouldn't be the only metric informing an investment strategy but it is valuable nevertheless. And the good news is that the CAPE measure does allow us a rough approximation of a crystal ball for future returns based on current market valuations. 

The idea here is to break down the various components of past returns and then use these valuation metrics to forecast through into the future based on variables such as national GDP growth rates or returns from dividends. If anyone is going to make a decent stab at this forecasting game, Rob Arnott and his colleagues at US firm Research Affiliates are likely to be among the most trusted. They've been constantly tracking returns from fundamentals based investing for the last decade and they've just updated their excellent ‘Expected Returns' website . The chart to the side summarises the range of expected returns for a bunch of varying asset classes, with real expected returns compared to likely volatility. 

Emerging market equities come out top in terms of potential returns with annual returns of nearly 7% (real) likely over the next decade, but that bumper potential profit comes at a likely cost, with very high levels of volatility. Investing in emerging markets currencies looks a slightly less scary trade, with returns of over 4% but much lower levels of volatility. US Small caps look a terrible idea with negative likely returns but massive volatility while the most depressing numbers concern global equities - potential real returns of not much more than 1% per annum. The site is freely available and the clever tools there allow the user to compare Research Affiliates’ long-term return expectations across a variety of geographies and asset classes. Crucially the site has just been revised with updated quarterly numbers (it was first launched in Q2 this year). In my view this website is an absolute must for any investor interested in the long term. 

 

Much the most interesting bit of this Research Affiliates analysis – and the bit that rings truest for this investor – is the deep dive into national markets and their relative valuations. The graphic below charts different nations while the second table below looks at individual markets in more detail. Its powerful stuff and it suggests that the UK equity market does look to be compelling value. 

 

The current CAPE measure for the UK is around 12 times earnings, well below the median value of the last few decades and likely to produce an “expected return” of 5.1% above inflation over the next decade. This compares very favourably with US equities where the expected return is less than 1% - the UK market even beats Japan where the current CAPE is 28 times earnings and expected returns 3.9%/. Investors in Brazil and Russia by contrast could be set for even bigger returns, especially as both have collapsed in value in recent months. The Research Affiliates analysts’ reckon that Brazilian equities (at just 9 times earnings) could be set for real (after inflation) returns of 9% per annum, while Russia could be kicking in returns closer to 13% (based on a CAPE measure of just 5 times earnings). Obviously these stellar returns from two key BRIC markets are likely to come as a consequence of very volatile markets – in both cases volatility is likely to be at least twice the rate seen in the UK. 

My own suspicion is that these estimates for Brazil and Russia are arguably a tad optimistic. Valuations do matter of course but there’s also a whole myriad of other considerations not least political/corporate governance and national resource dependencies that need to be factored into the equation.

 

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The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only. Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment. Links to external websites are not operated by or affiliated with Societe Generale. While we aim to point you to useful external websites, we cannot be responsible for their content or accuracy. Societe Generale takes  responsibility for the views expressed on any external websites or any liability arising from investment decisions you may make. You should seek professional advice if any of the content of this page is unclear.

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