The Difference Between Then and Now

I read stuff from young commentators today and wonder how they could write such insightful commentary. It is hard for me to remember the quality and depth of insight I had when I was a similar age.

But as I reflect upon some of my writings and insights from when I first entered the industry, the quality and depth of those insights were not all that much different from the good stuff I see from young commentators today.

What has changed for me is a more honed approach toward investing (stripping away the dross) and a greater skepticism toward smart people based on those 25+ years of experience. Whereas I was trying to work out what works and what doesn't back then, today I have a greater appreciation for messiness of life.

Peak China

I am not saying China has peaked. Far from it. China will do nothing but continue to grow in size and influence throughout the 21st century. The 21st century is the Chinese century (22nd century is India's).

What I am saying is the current reverence and awe for China and its seeming infallibility in the face of Western incompetence and decline reminds me of peak Japan back in the 80s. On the face of it China appears to have pulled off a seemingly perfect emergence.

Beneath the surface there are many cracks (overcapacity, overindebtedness) and with increasing commitments both at home and worldwide, China will be found to be fallible.

Just sayin!

Equity Glide Path and Sequence of Return Risks

Being new to retirement issues, I find this area very interesting.

A counterintuitive idea is to increase the equity glide path once retirement hits, ie. increase equity exposure over time. Start at say 20% equity exposure and increase it 1% or 2% per year (by redeeming cash/bonds for withdrawals). One of the benefits of such an approach is not getting caught out on the sequence of risk issue associated with poor equity returns early in retirement. I kinda like that idea. (but only in a high valuation environment)

"These results indicate that the optimal equity glide path (as well as the decision about whether to use T-bills or bonds) is in fact quite sensitive to the market valuation at the start of retirement (and indirectly, to expected market returns). While the accelerated rising equity glide path worked best in some scenarios, the fixed 60% equity portfolio did better in most. The rising equity glide path should only be considered in unfavorable valuation environments. Notably, though, the “traditional” steady declining equity glide path is still inferior to some other strategy in all valuation environments. Based on historical data, more aggressive portfolios are rewarded in favorable (undervalued) and neutral environments, and rising equity glide paths performed better in unfavorable market environments, which were the situations that generated the overall historical SafeMax."

Definitely food for thought.

Graham and Dodd tactical allocation rules based on market PE

From Kitces and Pfau in AAII.

Though there are a multitude of ways to define an undervalued or overvalued market, we rely on the switching rules developed long ago by Graham and Dodd (“Security Analysis: The Classic 1940 Second Edition,” McGraw-Hill, 1940). They suggested maintaining the neutral asset allocation when valuations fall within a range between two-thirds and four-thirds of their historical average value. Graham and Dodd increase the stock allocation when valuations are less than two-thirds of their average, and decrease the stock allocation when valuations are more than four-thirds of their average. These numerical bounds correspond to evolving CAPE values of approximately 10 and 21 over time. Given the volatility of the CAPE ratio, these bounds also roughly correspond with the bottom and top quintiles of the historical valuation distribution, which are CAPE values of 11.1 and 21.2 (see Figure 1).

These results suggest that the valuation-based approach is generally superior to the rising equity glide path approach and the fixed equity allocation portfolios, as the valuation-based scenarios produce comparable-to-slightly-better results across the board. 

Average Market Multiple and Its Standard Deviation

Was playing around with Shiller's CAPE database and was curious what the standard deviation of the market multiple was.

Arbitrarily choosing the period 1965 to 2015 the long term average CAPE was 19.7x with a standard deviation of 8.2 (hi = 44.2x, lo = 6.4x).

Using the same period but using a naive PE (ie. non-smoothed), the average market multiple over the period was 18.9x with a standard deviation of 12.6 (hi = 123.7x, lo = 6.8x).

Breaking the period into 5 yr, 7 yr and 10 year rolling periods to simulate various cycles the PE and standard deviations came out to:

		CAPE				Naïve PE
	5 Year	7 Year	10 Year		5 Year	7 Year	10 Year
Average	19.29	19.26	19.20		19.05	18.82	18.49
Standard Deviation	7.83	7.71	7.52		7.64	7.08	6.80
Hi	36.50	33.48	31.10		33.16	30.76	31.43
Lo	8.59	8.87	9.39		8.10	8.81	9.37

Pressure Points In The Market

I just took a look at areas of prospective bubbles in the market the other day and concluded there was nothing significant poking its head out. But I wanted to revisit that question and articulate or expand on a couple more pressure points in the market today:

1. The large decline in oil prices has crushed the energy sector which had been one of the drivers of growth in the US. There may be more risk and implications there than what the market is indicating.
2. The large decline in commodity prices, predicated on the slowdown in China, which has crushed Australia, Brazil and Canada. Australia, China, Canada and the UK have large residential real estate bubbles.
3. ECB QE and the financial repression of NIRP is leading to a recalibrating of currencies and a fight to the bottom. 
4. Japan QE and rebalancing could push Japan over the edge as the curtain is finally pulled back.
5. Geopolitical risks could escape beyond borders and proxies - Ukraine, Syria.

More On The Purpose and Role of Active Management

Most retirement plans offer a menu of index funds and active funds. The active funds typically comprise brand name, "institutional quality" managers. They are in essence a safe bet from a performance, business and career risk perspective. They will likely deliver somewhere between 1% outperformance to -2% underperformance (which incidentally is acceptable). They are the proverbial closet indexers. You may wonder what is their role. If they can't and aren't trying to generate genuine outperformance (alpha), then why use them. I think the reason is as alluded to previously (business, career and performance risk management) but also because they serve several other important purposes.

Namely, they provide the potential for outperformance (an important psychological factor). And they do provide some degree or potential of downside mitigation. Both of which meet the needs of most investors to believe that their fund is being managed by an expert and provides them with a positively skewed opportunity set.

Hard to know whether this is a cynical take on active managements role or simply the reality, which although it is unlikely to deliver alpha, actually does provide investors with a degree of comfort.

If plan providers were to offer "genuinely active" managers then the outcomes could be a real mess. The hit rate on finding and getting a genuinely active manager who then outperforms is pretty low. Not worth the risks and hassles associated with it.

Genuinely active = relatively new fund (less than 3 years old), concentrated bets, small amount of assets under management.