A World Of “Meh”

Right now, a lot of people are sitting out there trying to decide whether to dip-buy this market. They want to tick the bottom. Perhaps you are one of these people. In my own humble opinion, they are fools–fools engaged in a foolish game. Most will ultimately do more harm to their net worth than good, whipsawing themselves based on “sentiment” (a.k.a what they are seeing and hearing from the financial media).

For some perspective, I want to revisit forward-looking return expectations from a couple of different sources.

The chart below looks at prospective 10-year S&P 500 returns as a function of the equity share of US financial assets (a mouthful, I know). This is similar to the Buffett Indicator of stock market capitalization/GDP. The data runs through 3Q18, which is the most recent Z1 release from the Federa l Reserve.

(As far as I know, Jesse Livermore at Philosophical Economics was the first to do a deep dive into the efficacy of this model. David Merkel at Aleph Blog used to update it quarterly. Since David seems to have abandoned the project, I’ve decided to pick this up on my own)

Data Sources: Federal Reserve, Morningtsar

The predicted forward return bottomed in 1Q18, below 5% nominal. Since then, the proportion of equities to total assets has decreased a few points. This corresponds to a modest increase in predicted return over the next 10 years, to approximately 7%.

The second chart is an updated expected return bar chart from Research Affiliates:

Source: Research Affiliates

RAFI’s methodology is the simple model discussed in my post on investment return expectations. RAFI’s estimates are even less inspiring than the equity allocation model. Here US Large Cap is expected to return about 2.7% nominal over the next 10 years.

If we weight each forecast 50/50 to account for the inevitable errors and uncertainty, we get something like 4.8% as an expected return for US Large Cap Stocks over the next 10 years.

To which I say: “meh.”

This is neither a “run for the hills” number nor a “go all-in” number for someone whose investment strategy is oriented around asset allocation over a long time horizon. In fact, it’s rare to arrive at either of those conclusions from an exercise like this. Which is the whole point. For most of us, our reaction to most market moves should be “meh.”

Now, this certainly isn’t the only lens through which you can view financial markets. A trader or trend follower can safely ignore everything I’ve written here. Traders and trend followers are playing an entirely different game. Same for pure, bottom-up stock pickers.

However, most of us building portfolios for institutions and individuals are not traders, trend followers or pure, bottom-up stock pickers. We’re asset allocators who merely need to be directionally correct about the performance of a handful of different asset classes over a couple of decades.

How does a fundamentally-oriented allocator invest in a world of “meh?” 

I’d suggest the following core principles:

Balance. Never make “all-in” or “all-out” calls. Investing is an exercise in decision-making under uncertainty. It’s a probabilistic exercise, except we don’t know the “true” probabilities of the various outcomes. Only fools make all-in, all-out calls when making decisions under uncertainty. And yes, gunslinging hedge fund guys, fools who make all-in, all-out calls can become billionaires.

Prudence. Don’t reach for yield or return. Our world is overrun with yield pigs, but they’re generally not being well-compensated for the incremental risks they’re running to juice their returns. And yes, middle market private credit investors, that’s directed at you.

Flexibility. As Henri Poincaré famously said, “geometry is not true, it is advantageous.” Asset allocation is similar. You become overly attached to particular asset classes, strategies and their historical performance at your peril. And yes, “VOO for the long run” investors, that’s directed at you.

Creativity. If the financial markets are giving you “meh”, consider changing the way you play the game. For individuals, that could mean saving more, or starting a business to generate wealth through “real world” economic activity. For institutions, it’s tougher to make those kinds of changes, but mostly for political reasons.

It is a frustrating thing, to be stuck in a word of “meh.” But recognizing it and acting accordingly is a hell of a lot more productive than staring at your E-Trade account trying to tick the bottom for SPY.

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