Harry Markowitz published his research titled “Portfolio Selection” in The Journal of Finance during 1952. He led with: “The process of selecting a portfolio may be divided into two stages. The first stage starts with observation and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performances and ends with the choice of the portfolio. This paper is concerned with the second stage.”
What about the first stage, the assumptions?
Strategic Asset Allocators aka “Buy & Holders” have reiterated their mantra in concert with Dr. Markowitz, that yes, investors should only be rewarded for taking risks that can’t be neutralized. Yes, stocks have more risk than bonds and over time have realized higher returns. BUT, what if your timeframe isn’t 75 to 100 years and there is no such thing as earning average 10% returns.
What if my timeframe is 10 to 20 years? Markowitz said you should reflect upon historical 10 to 20 year horizons for your assumptions. That is the first stage to which Markowitz referred—before MPT can be applied to your portfolio.
One characteristic that is blatantly obvious for the two halves is the starting level of valuation in the market as determined by the price/earnings ratio (P/E). It’s the bellwether measure of prices in the stock market. Almost unanimously throughout the past century, when the P/E is above average, subsequent returns are below average. As well, below average P/E’s drive above average returns.
So since the current P/E is well above average, shouldn’t the assumption for Markowitz’s model be below average returns?
Let’s take a look.
1900 – 2020
Even an extended period of 20 years does not ensure historically-average cumulative returns in the stock market. Returns are dependent upon the level of valuation (P/E) at the start of the period. When the stock market P/E is relatively high and above the average, investors’ returns over the subsequent 20 years have been below average. When P/E is relatively low and below the average, Investors’ returns have been above average and rewarding.
Investors can spend only compounded returns (i. e., geometric), not average returns (i.e., arithmetic). This chart presents the difference between average returns and compounded returns for investors. The two issues assessed are the impact of negative numbers and the impact of volatility as measured by the variability within a sequence of returns. Both issues can devastate the actual returns realized by investors compared to the average.
The first issue-negative numbers—is demonstrated by this example: a gain of +20% and a loss of -20% may average zero, yet the net result is a loss regardless of the order in which they occur (100 + 20% = 120 — 20% = 96 or 100 – = 80 + = 96).
The second dynamic—volatility—is illustrated by another example: the compounded return from three periods of 5% returns is greater than any other sequence that averages 5%.
When slower growth reduces the contribution of earnings growth to total retum, another source of return is therefore needed to fill the shortfall. Stock market investors will not be willing to take equity risk without appropriate equity returns. If bond yields do not change, they will not compromise stock market returns. In this situation, stock market investors will step away until the price of the market declines to again provide appropriate returns. This is the function of markets—finding the price that provides a fair retum.
This discussion relates to the effect from changes in the growth rate of earnings. To isolate that factor, several assumptions are needed. This will ensure that the relevant relationships remain the same. First, based upon the previous economics discussion, a downshift in economic growth drives slower eamings growth. Second, long-term profit margins remain similar under both growth scenarios, thus slower earnings growth is consistent with the downshift in economic growth. Third, the inflation rate remains constant across both scenarios for growth. Fourth, the expected return for stocks and bonds as well as the related equity risk premium for stocks does not change across both scenarios for growth. In other words, the relevant relationships remain the same.
Of the three components of stock market returns, two are available as sources of retum, and the third one represents the way in which returns occur. The first source of return, EPS growth, is defined in this example as either providing 3% or 2% toward to the total return. As a result, the second source of return, dividend yield, will need to increase to compensate for lower earnings growth in the second scenario. Herein is the role of the third source of stock market returns: changes in P/E.
The dividend yield rises as P/E declines and vice versa. For the stock market to be positioned to provide equity-level returns, investors will look for the lower price that enables the dividend yield to rise sufficiently to offset the loss of eamings growth. The required decline in P/E varies based upon the starting level of P/E.
If P/E starts relatively high, then a higher decline is required to provide the required dividend yield increase. For example, if EPS growth drops by 1%, then the change in P/E required to increase the dividend yield by 1% is 7 points from 22 to 15, 4 points from 15.5 to 11.5, and 2 points from 10 to 8.
This shift in P/E relates only to the change in eamings growth. P/E would then be further affected by changes in the inflation rate. This figure provides another graphic illustration of the dynamics of shift and cycles. The shift is related to changes in growth rate and the cycle is driven by inflation rate trends and levels.
So should we assume a buy and hold allocation with the same stocks/bonds mix is prudent now?
Or would a 40/60 or 30/70 allocation be more reasonable?
Price is what you pay, value is what you get.
– Warren Buffett