What’s patience worth? Possibly a lot.
If you lost your job would you
[a] look for another job and adjust your living style accordingly
[b] look for another job and try supplementing your lost income by betting at the race track?
Today it seems most investors are managing their portfolios according to some variation of [b]: in the face of lower prospective returns they move higher on the risk scale instead of adjusting their expectations. Not one week goes by without an interlocutor – client, prospect or friend, it does not matter – spelling it out for me: “I get it, equities are overvalued, but where do I put my money today if I sell?” The real question should be “How do I navigate this extended period of low returns?”, but no one seems to care and so risk profiles are dragged higher in search for “yield.”
How much are we likely to “lose” by foregoing “yield” today and staying prudent until better times come? I played with some numbers; “playing” here means trying to get a sense of the magnitudes, not making predictions: for goodness sake, you should know by now I am allergic to them. Figures 1 and 2 will help understanding the type of outcomes we might expect from different strategies over a long enough period of time. How long? John Hussman has often shared this graph which he considers the most relevant in assessing potential future equity returns from current valuations; its horizon is 12 years:
I will use the same 12-year time horizon, make some assumptions on market returns and on the management of two valuation-driven tactical strategies, and compare the results against a passive 50/50 stocks/bonds allocation. (*)(**)
Figure 1 shows one possible outcome for the three strategies, where equity returns are a smooth 2% per year (approximating the period compound return suggested by Hussman’s graph) over the next twelve years. Strategy 1 and 2 begin heavily underweight equities and, gradually realizing their “mistake”, move to 50% by period end. While Strategy 2, using cash, is clearly penalized, the other two are broadly equal after an initial underperformance. Note this observation does not take into account the risk of a downturn avoided by both strategies.
If we hypothesize a more realistic return evolution, with higher volatility and a strong adjustment period (a drawdown of about 50% in years 2020-2022) to bring markets in line with acceptable valuations (but not to severely undervalued levels, which is more consistent with history), the results are likely to look like in Figure 2. The underperformance of Strategy 1 and 2 in the first 3-4 years is much more evident, but so is the recovery in subsequent years, aided by tactically moving back into stocks as the market retreats (and becomes more reasonably valued).
I don’t know what will happen in the future, but it seems to me that a little less “yield” today could save a lot of sorrow in the future.
(*) If you are among those who think we are at the inception of a new secular bull phase, read no further; equally if you are among those who think they will manage to exit when the signs of change will be plastered all over the sky.
– Initial yields (broad US stock market and broad bond index with duration of 6 years) equal to today’s values.
– Prospective stock returns as Hussman calculates from above graph (around 2%); bond returns negatively correlated with equities’.
– Dividend growth 2% per year except in seriously down markets.
– Three strategies: Balanced (stable 50/50 stock/bonds allocation), Strategy 1 (equity allocation determined by Hussman’s valuation chart, gradually scaling in and out of equities versus bonds), Strategy 2 (same as Strategy 1, but using cash instead of bonds).
Figure 1 & 2: author’s calculations