The 2000s have been the worst decade for U.S. stocks in 200 years, reports yesterday's Wall Street Journal. Meanwhile, it’s been a somewhat better decade for the Global Market Index, a passively weighted mix of all the major asset classes that's the benchmark for our sister publication, The Beta Investment Report.
There are still two weeks left to 2009 and the decade and so it's not over until it’s over. But barring a massive change in prices in the days ahead, the mystery is fading quickly for year- and decade-end numbers. Using performance through the end of last month, the 10-year annualized total returns for the major asset classes and GMI stack up as follows:
U.S stocks were dead last, returning a trifling 0.1% on an annualized basis for the past 10 years. By contrast, the best performer among the major asset classes has been emerging market bonds, which soared by an 11.5% annualized total return. As for our Global Market Index, it returned 4.2% over the past decade.
GMI’s more or less middling performance isn’t surprising. As a market-weighted asset allocation of all the major asset classes, our index embraces the world’s assets as they are. It is a naïve benchmark of everything, presuming nothing other than the idea that there’s some degree of embedded wisdom in the valuation of assets as collectively assigned by investors.
Did some of us do better? Yes, although some of us did worse. Although this is just a guess, it wouldn’t surprise this observer to learn that more than half of the planet’s efforts to "beat the market" trailed GMI. So it goes. A robust definition of "the market" is a competitive beast over the medium and long term.
Should we give up hope of engineering a better outcome than GMI over time? No, not necessarily. As GMO’s Jeremy Grantham notes in today’s Journal article, "We came into this decade horribly overpriced" in terms of stocks. The message: prospective equity returns a decade ago looked unattractive if not horrible, a point that Grantham and a few other contrarians made at the time.
We can argue if various market clues (dividend yield, volatility trends, yield curves, etc.) about future performance are a sign of market inefficiency or evidence of time-varying expected returns in a reasonably efficient marketplace. The better question: Should we act on this information? If so, when? And under what conditions? Sometimes—sometimes—these clues provide compelling reasons to adjust Mr. Market’s asset allocation.
Unfortunately, the clues aren’t always as clear and potent as they were at the end of the 1990s for stocks, when expected return for equities--U.S. equities in particular--looked unusually low. Peering into the future isn't always so investor friendly. Sometimes, arguably most of the time, the outlook is murky. That's one reason why besting an expansive definition of the market (i.e., GMI) is so difficult for so many of the world's investors over time. Yes, some beat the odds, although not so many as conventional wisdom suggests after adjusting for risk.
The good news is that different asset classes dispense different messages at different times. In other words, a relatively potent signal about future risk and return may be reflected in one or more asset classes at any point in time, which provides a basis for adjusting the passive asset allocation. That was certainly true at the end of 2008 and early this year. The problem is that the outlook for most asset classes is usually a gray area, as it is now. That suggests holding something approximating the passive allocation for that asset class until better information comes along.
Knowing when to hold ‘em, fold ‘em or overweight ‘em is the central challenge in strategic-minded investing. The academic and empirical record in support of managing money along these lines is compelling, as we detail in our upcoming book Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor.
Meanwhile, forecasting risk premiums for the major asset classes, GMI and our trio of model portfolios on a monthly basis is the raison d’etre of our monthly subscriber-based newsletter, The Beta Investment Report. Our current forecast for GMI’s risk premium is roughly 2.5%, well above the 0.4% delivered over the past 10 years. (Risk premiums are returns in excess of the risk-free rate, such as the return on a 3-month Treasury bill.) Not surprisingly, our modeling tells us that the component asset classes offer an array of prospective returns above and below our expectation for GMI. Par for the course.
Figuring out which asset class looks compelling, or not, keeps the midnight oil burning in the offices of The Beta Investment Report. Coming up with robust forecasts isn’t easy, nor is it foolproof. Suffering all the usual caveats that bedevil mortal efforts at divining the future, we assume a fair degree of error in our predictions. That said, the road to strategic insight is smoother if we routinely assess the outlook for risk and return cautiously, do so for all the major asset classes through a variety of techniques, and generally remain humble in deviating from GMI's mix until the numbers strongly suggest otherwise.
Accordingly, the fact that U.S. stocks dispensed an dreadful 10-year run is but one piece of a larger strategic puzzle. The more valuable perspective begins by recognizing that a passive allocation to everything is likely to continue dispensing middling levels of return and risk in the years ahead. That’s hardly a silver bullet, but it’s a solid foundation for analyzing markets, developing some intuition about future risk premiums and deciding what looks compelling, and not so compelling, for second-guessing Mr. Market’s asset allocation.
This post has been republished from James Picerno's blog, The Capital Spectator.
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