What really constitutes a return? If I want to be a geek about exploring this question, PhDs Richard Grinold and Ronald Kahn offered a more-than-exemplary answer in their 1999 publication, Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Controlling Risk. In near-Einstein fashion, these two masterminds broke down the complexity of this topic into one simple formula, referred to as “The Fundamental Law of Active Management”: Investment Return = Skill * Opportunity.
Like it or not, we need to confront this elaborate topic, as the investing community is seemingly going unreasonably gaga over expected future market outcomes. Since we concluded our HighTower investment conference last week in New York, I have kind of started to worry: The most successful analysts and money managers (the skilled, for our purposes) continue to be quite bullish about stocks, with year-end projections for the S&P 500 ranging anywhere from 2150 to 2350 points, and longer-term possibilities including the “unleashing” of an equity super-cycle which would have the index nearly double from current levels.
In my view, it is becoming more likely that the collective excitement will be marked in history with “we should have seen this coming …” To be clear, I am not predicting the end of the current equity bull, but if we are made to believe that a market trading at an 18x (12-month forward) earnings multiple (in the U.S.) still is a good deal, we are not being critical enough. The Shiller P/E, known as a market valuation indicator, is currently marked 68 percent higher than its mean, and, based on renowned GMO investor Jeremy Grantham’s asset class forecasts, we should expect negative returns for U.S. stocks over the next seven years. If those arguments are not convincing enough (I already know my critics), even Mr. Buffet's best single measure for valuations, Total Market Cap/GNP, has reached 120 percent—a data point that was higher only during the tech bubble in 2000.
On the other hand, there is the “this time it’s different” crowd, usually a precarious movement to follow, but still worth noting. A common argument is that, in the absence of “safe returns” (or income) in bond markets, equities are still inexpensive on a relative basis and/or investors are willing to “reach” for returns (i.e., speculate outside their normal suitability framework). Related to this argument are two aspects to consider, both of which make the story less compelling: 1) Global issuance of debt, especially high-yielding “junk,” has reached record proportions to cater to income-dependent investors—likely another bubble in the making that will become problematic should an increase in rates require the “repricing” of debt; and 2) To justify current equity valuations in the U.S., short-term rates would have to stay low for another 25 years.
Clearly, in order to make sense of risk and opportunities offered in financial markets, clients will want to hire managers that are skilled (a great discussion can be found here), but opportunity is the other crucial component to investment success. If we choose to assign credibility to the aforementioned active-management formula, then skilled managers could be challenged either by other managers that are better skilled or by a shortage of good opportunities. The latter in mind, it should not be a shocker that the price paid for an asset will ultimately determine the rate of return (once sold); therefore, given current valuations, the opportunity set is likely not tilted towards owning bonds over equities in general, or, more specifically, U.S. stocks over other global choices.
In the mood for a musical closing remark: citing Mr. Bruce Springsteen’s 1980 song, The Price You Pay: “…. now they’d come so far and they’d waited so long, just to end up caught in a dream where everything goes wrong…” Let’s not get greedy here.
Matthias Paul Kuhlmey is a Partner and Head of Global Investment Solutions (GIS) at HighTower Advisors. He serves as wealth manager to High Net Worth and Ultra-High Net Worth Individuals, Family Offices, and Institutions.
