Value can be defined as the intrinsic worth of an asset based on underlying fundamentals. In the case of financial assets such as stocks, valuation is determined by the stream of future cash flows expected to be generated from the investment. The most popular of these measures for stocks is the price/earnings ratio (P/E), which measures the amount paid for a dollar of earnings. More sophisticated variations of this measure have not surprisingly proven to be good indicators of future long-term returns.
Successful investing is about weighing projected risk and reward. When the opportunity set of available investments is artificially distorted, this job becomes extremely difficult. Such is the case now, with short-term rates being held at near zero levels, resulting in little to no reward for holding short-term, traditionally low-risk investments such as T-Bills, CDs and money market funds. To have any hope for a positive return (before inflation), an investor in today’s market must be willing to assume risk. But does that make it a good idea?
When Federal Reserve Chairman Ben Bernanke announced the program to purchase treasury securities last year, he stated one of the objectives was to raise the prices of other financial assets (stocks, bonds, etc.) beyond the levels they would otherwise be. Holding short-term interest rates at near-zero levels has the same effect, leading investors to takes risks they otherwise would shun.
However, while tempting, a lack of attractive alternatives is not a reason to accept investment risk. Today, as always, the overall level of risk an investor assumes should be determined by his or her time horizon, objectives, financial situation, and available opportunities. When evaluating these opportunities, it is also important to consider valuations of the various investment classes (stocks, bonds, real estate, commodities, alternatives) being examined.
Paying attention to valuation means increasing exposure to risky investments when valuations and projected returns are attractive, and paring back exposure as valuations become stretched and projected returns decline. Some call this market timing. Others prefer to think of it as a prudent and responsible way to manage and protect capital, and generate long-term returns.
Buy-and-hold investing became very popular in the 1980’s and 90’s for several reasons. It had the backing of the academics in accordance with the efficient market hypothesis, it was easy to manage, and above all, it worked. During that period, the only thing an investor had to do to realize out-sized returns was to stay invested. But of course that is hindsight. The fuel for the spectacular returns of the 80’s and 90’s was the low valuations that existed in 1981-82, when stocks had been left for dead. Adding significantly to these gains was the fact that, far from stopping near an average or “fair” valuation, the market continued to climb until the S&P 500 reached record high valuations in early 2000.
Unlike the 80’s and 90’s, the past decade has not been kind to investors. Excessive debt, the housing/credit crisis, and slowing economic growth (all of which are related) have coincided with near-zero returns over the past decade. However, the severity of this sub-par performance owes to the fact that we began the decade (2000) with excessively high and unsustainable valuations. In other words, returns since 2000 have been poor in large part because stock prices began the decade at such a high level. In fact, if we had begun the decade at an historic “fair” valuation, the average return for the decade would have been around 8-9% – near its average and far from a “lost decade”.
John W. Pfenenger II, CFA, is the President of Prism Capital Management, LLC. He has over 20 years of experience in investment management, research, and consulting. His career began as a portfolio manager at Mellon Bond Associates (now part of Mellon Capital) in Pittsburgh, PA, and continued at Mitchell Hutchins Institutional Advisors in New York, NY, and later at the Asset Management Group of National City in Cleveland, OH. His institutional clients included pension funds, foundations and endowments, insurance companies, collective trusts, and mutual funds. John holds an undergraduate degree in business from the University of Missouri – Columbia, and a Master of Science in Industrial Administration degree from Carnegie Mellon University. Prism Capital Management, LLC (Prism Capital) is an independent, fee-only Registered Investment Advisor in the state of Missouri. The firm provides investment consulting and management services to individuals, retirement plan sponsors, charitable endowment funds and other not-for-profit organizations. John can be reached at email@example.com.
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