Don't Give Me Any Static (Allocations)
There’s been significant research conducted by academics and practitioners alike on the key determinants of investment returns. The vast majority of that research points to two unavoidable conclusions: 1) it’s tremendously difficult to predict performance over weeks or months with any reliability, and 2) the price that you pay (i.e., the valuation) is THE key determinant of long-term return over a 10-to-12-year period. If you doubt this, simply look at the greatest and wealthiest investors in just about any field, be it real estate, stocks or bonds, and then look for the single word most often associated with their style of investing: value. The most successful investors seek out and find value where others do not, be it in growth or value stocks or any other sector, style, or asset class.
A time horizon of 10 to 12 years is a very long time for many investors, especially those that may need to access their investments in the nearer term. Most, if any, are unable to wait for the next low point in valuation to commit all of the money they will ever invest and then wait 10 or more years. This is one reason why we choose an 18-to-24-month medium-term horizon for much of our research and analysis. While we begin with a long analytical time frame and base our neutral allocations on a longer-term outlook, we overweight (invest more) or underweight (invest less) in different asset classes based on their medium-term outlooks. We utilize various factors, like interest rates and leading indicators, that can and often do influence medium-term performance. But we always choose to start with valuation, because if you pay too much for something, it’s tremendously difficult to overcome that mistake.
Just like the date I wrote on one of my high school math tests, “Today Is the First Day of The Rest of My Life” (which Mrs. Long did not find so humorous), each new day begins a new period of returns. So, if you already own an investment, its future 10-year return is also equally influenced by its valuation today.
Presently, by just about any measure of valuation, most assets are tremendously expensive. By some metrics, equities are as expensive as they were in the dot-com era from 1998-2000, and many market observers have lately compared current equity valuations to 1929, before the crash that started the Great Depression. These valuations are striking on their own, but even more so when you consider the fact that 14% of our workforce is unemployed or under-employed; corporate bankruptcies have skyrocketed; the number of unprofitable small public companies is near the all-time high; the number of large and smaller businesses that struggle to make enough money to pay the interest on their debt (so-called zombie companies) is near 20% of all existing U.S. corporations; and our country’s debt-to-GDP is on track to pass a key level that research suggests is likely to constrain future economic growth.
No matter how you look at it, valuation stands at a level that’s historically consistent with meager-to-negative long-term returns. On top of this, consider that our Federal Reserve now wishes to create inflation that averages 2%. Said another way, they’re targeting average inflation that devalues the purchasing power of your money and the value of your investments by half every 35 years. The challenge of saving and investing to provide enough purchasing power to support your lifestyle and financial goals has rarely been more formidable.
Lest you think otherwise based upon these ugly observations, we are also witnessing signs of economic rebound, and we do believe global economies will eventually recover. But to achieve high-quality investment returns, optimism is not enough. We cannot expect high-quality returns from a static process that ignores current valuations as well as current and future economic conditions. We believe it’s not prudent to blindly or systematically purchase a basket of stocks and bonds and other investments at current high valuations, hold them over the next decade, and hope it will somehow just magically work out. There have been several 10-to-20-year periods when following a static “buy and hold” strategy would have earned investors zero return.
Periods of meaningful over-valuation tend to lead to significantly disappointing returns or even losses. Those disappointments then give way to periods when very attractive valuations make it possible to achieve significantly higher long-term returns. Now, perhaps more than at any time in our professional careers, we feel we must be dynamic to avoid large losses and capture good opportunities. We must be patient, wait for changes in valuation and economic conditions, and then meaningfully invest when the odds are in our favor. It’s not easy. If it were, we would simply be average, which is likely not going to be a great thing to be over the next 10 years or so.