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By Noah Solomon
Special to Financial Independence Hub
Same old story, same old song
Goes all right till it goes all wrong
Now you`re going, then you`re gone
Same old story, same old song
— B. B. King
Voting Over the Short-Term vs. Weighing Over the Long-Term
Famed investor Benjamin Graham, widely known as the father of value investing and (Warren) Buffett’s mentor, said “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” Graham’s statement captures the very essence of market behaviour since time immemorial.
Over the course of any month, quarter, year, or several years, there are any number of factors that can influence the returns of any single stock, sector, or asset class. Whereas these factors are numerous, the main “culprits” are usually behavioural in nature. Greed and fear, panic and euphoria, herd mentalities, and other emotional biases have historically been the key drivers of short- to medium-term movements in security prices.
Importantly, these forces can become sufficiently extreme as to cause prices to become largely disassociated from fundamentally justifiable levels. Looking at past bubbles (and subsequent collapses), the stories are remarkably similar. The Dutch Tulip Mania of the mid 1600s, the South Sea Bubble of the early 1700s, the roaring 1920s, and the dotcom bubble of the late 1990s were all spurred by euphoria, herding, fear of missing out (FOMO) and “it can only go up” mentality which ended in tears and losses. On the flipside, the subsequent loss of confidence and despondency eventually set the stage for above-average gains over the ensuing several years.
The (not so) Simple Keys to Successful Investing
Fundamental valuations, which lie at the heart of Graham’s long-term weighing machine, are the “anchor” of equilibrium prices that foreshadow neither higher- nor lower-than-average returns (or losses). Historically, whenever valuations have stood well above their long-term averages, returns over the next several years have tended to fall in the range of disappointing to outright painful. Conversely, when valuations have stood well below their historical averages, performance over the ensuing several years has tended to range from higher than average to stupendous.
So, in theory, the keys to successful investing are simple:
- Have low exposure to securities or asset classes whose valuations are well above their historical averages.
- Have high exposure to securities or asset classes whose valuations are well below their historical averages.
- Have average exposure to securities or asset classes whose valuations are neither well above nor well below their historical averages.
If only Life were so Simple
Before you thank me for handing you the golden key to achieving better than average returns with relatively low risk, you should know that this approach comes with baggage that can make it difficult if not impossible for many to follow.
Although valuations have proven to be a very good predictor of longer-term, average returns, the same cannot be said over the short to medium term, for the simple reason that they tend to overshoot. One should never underestimate the ability of ridiculously valued assets to become even more so.
Behaviourally-fuelled momentum (both positive and negative) can take on a life of its own, even in the face of deteriorating fundamentals. Alternately stated, a purely valuation-based approach to investing inevitably involves suffering severe FOMO when overpriced assets continue to rise after you have reduced your allocation to them. Similarly, increasing your allocation to undervalued assets is likely to cause pain when widespread despondency and suspicion cause them to become even more undervalued. Recalling the dotcom bubble of the later 1990s, renowned investor Jeremy Grantham stated:
“In late 1997, as the S&P 500 passed its previous 1929 peak of 21x earnings, we rapidly sold down our discretionary U.S. equity positions then watched in horror as the market went to 35x on rising earnings. We lost half our Asset Allocation book of business but in the ensuing decline we much more than made up our losses.”
Head in the Oven and Feet in the Freezer: On Average you feel Fine
The traditional, passive allocation of 60% equities/40% bonds has delivered admirable returns over the past several decades. Since 1979, a 60/40 portfolio made up of U.S. equities and bonds has delivered a 10.2% annualized return, outpacing inflation by 7%. Since 1900, this portfolio has delivered an annualized real return of about 4.8%. While the longer-term numbers are materially lower than the 1979-to-present period, they have nonetheless been sufficient to meet most investors’ needs.
Given that the 60/40 portfolio’s performance has ranged from satisfactory to excellent over longer time periods, why not just succumb to the passivity gods, sit back, and relax? The problem is that the passive portfolio’s long-term historical track record masks some significant blemishes. Importantly, these setbacks cannot be considered “black swan” anomalies in terms of their frequency. There have been six periods in which the 60/40 portfolio would have either broken even or lost money relative to inflation. Making matters worse, these periods lasted an average of 11 years.
The Common Element & Recent Echoes of History
Unsurprisingly, the six periods in which investors received either no or negative real returns all share common characteristics. Specifically, they all followed exceptionally strong periods of return, which in turn left them with starting points with either stocks and bonds or both trading at extremely high valuations.
Fast forward to the post-global-financial-crisis era. From the beginning of 2009 through the end of 2021, the passively allocated 60/40 portfolio delivered an annualized real return of 9.4%, which is roughly double its long-term average. This exceptional performance was powered by the combination of rapidly rising equity markets and a massive decline in interest rates. By the end of 2021, these developments left both the S&P 500 and real bond yields at some of their least attractive valuations in history. Given this setup, it is not surprising that public markets offered investors few places to hide in 2022 as both stocks and bonds suffered significant losses.
Where we stand today: Beware the Mean Reversion Boogeyman
Following the fastest rate hike cycle in 30 years, bonds currently offer reasonable yields. However, certain segments of equity markets, particularly in the U.S., continue to trade at excessively high valuations. Against this backdrop, the very same mean reversion boogeyman who has historically wreaked havoc following periods of much higher than average valuations could return, thereby leading to disappointing returns for conventional, passive portfolios.
The S&P 500 currently stands at or near its largest valuation premium in history relative to the rest of the world. In theory, this premium could be justified by superior earnings growth, particularly with respect to mega-cap growth companies. However, upon closer scrutiny, this argument doesn’t let the S&P 500 off the proverbial hook. Not only do U.S. stocks look extremely expensive on a price to trailing earnings basis, but also in terms of its price-to-forward earnings, which embed forward-looking growth on top of today’s high earnings. According to the latter metric, U.S. stocks currently lie at over a 50% premium to their long-run average. In contrast, markets in the rest of the world are trading either at or below their long-run averages, leaving a historically wide divergence in their valuations relative to the U.S.
Not only is there a historically wide valuation gap across markets, but also within them. The cheapest 20% of U.S. stocks are currently trading in the 6th percentile in terms of their relative valuation to the broad market. The corresponding figure for developed, non-U.S. equities is even more extreme, with the most attractively valued 20% of stocks standing in the 1st percentile relative to their more expensive peers. At the other end of the spectrum, growth stocks are historically expensive across the board. Within U.S. equities, the most expensively priced 20% of stocks stand in the 89th percentile in terms of their relative valuation to the rest of the U.S market. Non-U.S. developed markets are flashing similar extremes, with the richest fifth of markets trading in the 1st percentile from a relative valuation perspective.
The four most Dangerous words & taking the Other Side of Extremes
While it is possible that historical patterns fail to prevail in the future, I believe it is far more likely that they shall. In the words of Harvard Professor Carmen Reinhart, “More money has been lost because of four words than at the point of a gun. Those words are ‘This time is different.’”
Notwithstanding the fact that mean reversion from extremes is impossible to time precisely, those who are willing to heed historical lessons stand to outperform meaningfully over the medium to long term. Investors stand to benefit from reducing their exposure to U.S. equities in favour of their non-U.S. counterparts. Similarly, they would be well-served to trim their country-specific allocations to growth stocks in favour of value stocks.
The value oriented Outcome Canadian Equity Income Fund aligns well with these recommended portfolio adjustments. Importantly, since its inception over six years ago, the fund has delivered substantial outperformance with lower volatility and shallower losses than its peers in market downturns.
Noah Solomon is Chief Investment Officer of Outcome Metric Asset Management Limited Partnership..
From 2008 to 2016, Noah was CEO and CIO of GenFund Management Inc. (formerly Genuity Fund Management), where he designed and managed data-driven, statistically-based equity funds.
Between 2002 and 2008, Noah was a proprietary trader in the equities division of Goldman Sachs, where he deployed the firm’s capital in several quantitatively-driven investment strategies.
Prior to joining Goldman, Noah worked at Citibank and Lehman Brothers.
Noah holds an MBA from the Wharton School of Business at the University of Pennsylvania, where he graduated as a Palmer Scholar (top 5% of graduating class). He also holds a BA from McGill University (magna cum laude).
Noah is frequently featured in the media including a regular column in the Financial Post and appearances on BNN.
This blog originally appeared in the October 2024 issue of the Outcome newsletter and is republished with permission
