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Summary Basic market valuation fundamentals suggest that investors should prepare for more muted returns from their equity portfolios. Economy wide transformations led by technological progress also support decreasing returns on capital. Although this low return on capital environment is undoubtedly more challenging, there are 5 strategies that can help investors build and manage a portfolio of stocks more effectively. CNBC pundits, analysts, hedge fund gurus and amateur market watchers love to make predictions about the future. They hum and haw about macro forces. They discuss the possible impacts of a rate increase and they debate the importance of China as the world’s growth engine. They try and pinpoint what the next “game-changing” technologies or companies will be and they try and estimate what the overall market will do. This preoccupation with the future is certainly fascinating to seasoned market participants but what does it all mean for the majority of investors who most likely have a large portion of their savings exposed to the stock market or at the very least is considering where to allocate their savings? At the very least market fundamentals and economy wide transformations suggest that investors should prepare for more muted returns from their equity portfolios. Market Fundamentals Suggest More Modest Returns First and foremost, basic market fundamentals support more modest returns. In terms of valuation, the Shiller CAPE ratio for the S&P 500 (NYSEARCA: SPY ) which is a cyclically adjusted price/earnings ratio – has been stuck at around 27 which is high given the median of 16. This represents its highest level since 2000 and suggests that profits are far higher than normal and should either plateau or sink from these highs, a process that may already be underway . In addition, Morningstar’s price/fair value chart suggests that value is becoming harder and harder to find. In addition, the current 12-month forward P/E ratio for the S&P 500 is 16.7. This P/E ratio is above the 5-year average of 13.9 and the 10-year average of 14.1. These valuation indicators are a cause for concern as low starting valuations have historically been one of the best indicators of market performance. Whether we are in a bubble on the verge of popping is unclear, yet what is obvious is that when prices are elevated versus earnings, future gains will be lower. Economy Wide Transformations Suggest Return On Capital Will Continue To Decrease Nevertheless, there is something more significant going on than just above average stock market valuations. More fundamentally, there are transformational economic forces that are re-shaping our societies and thus our markets. The effects of this technological progress indicate that the return on capital (or cost of capital) will decrease as technological progress increases. Why? Because technology makes innovation cheaper and thus capital more abundant. Think back to the industrial revolution. During this period it was virtually impossible for someone to start a business without substantial capital reserves. This was due to the fact that innovation was cap ex heavy (commodities, infrastructure, wages etc.). Fast-forward to today and things have changed dramatically. It has never been cheaper to start a business and thus we have large (by market cap not by employee count) companies like Facebook (NASDAQ: FB ) buying companies with 55 employees like WhatsApp for $19 billion dollars. This is a world in which the barriers to entry are dropping across all industries. Such “new age” businesses generate enormous wealth for shareholders and entrepreneurs, yet result in comparatively few new jobs. Instead, what is generated is a rapidly increasing supply of capital. Corporations are piling record amounts of cash and thus we have a lower demand for capital which causes an increasingly higher supply. The higher the supply of capital, the lower the returns on capital. Yet the transformational change does not stop here. Not only does technology make capital more abundant, it also makes capital markets and the allocation of abundant capital more efficient. This is evidenced by the rapid adoption of algorithmic trading and information technology which makes the flow of information more efficient. In this environment arbitrage opportunities become more difficult to find as information asymmetries become more unusual. There isn’t a day that goes by without a high profile hedge fund manager bemoaning the lack of opportunities for return. Thus, the cycle continues: abundant capital chasing fewer return opportunities leading to even lower returns. Nevertheless, all is not lost. Although this low return on capital environment is undoubtedly more challenging, these 5 strategies can help investors build and manage a portfolio of stocks more effectively. 1) Reset Intuitions and Assumptions Since the market bottomed in March 2009 the S&P 500 has returned around 20% on an annualized basis. This amounts to a tripling in value rising by a staggering $12.8 trillion. So given the forces outlined above which suggests lower future returns what can be expected? Traditionally, for a diversified portfolio of stocks the typical expected annual return has hovered around 6-7% . Is this lower number even reasonable? Some leading investment analysts are suggesting that a more reasonable number would be around an average of 2% annual return, after inflation and fees. Thus, projecting an annual return of around 5% would be a more useful guide. 2) Reduce Investment Costs In light of projected lower future returns, controlling a portfolio’s various costs will yield major benefits over time. For example, paying a 1% expense ratio on a balanced portfolio that earns 10 percent on an annualized basis takes a 10% cut out of the return. Lower that 10% portfolio return to 5% and a 1% expense gets much more significant. As such, purge any mutual funds replacing them with low cost ETFs and be sure to use a low cost broker. 3) Reconsider Asset Allocation Beware of over exposure to bonds. Starting yields on Treasury bonds have explained much of their performance over the subsequent decade and with yields as low as they are, overexposure to bonds will almost guarantee low returns. On the other hand investors who maintain higher allocations to equities will be better positioned to eke out the best returns possible over time. 3) Invest In Quality And Focus On Dividends Effectively dealing with a lower return environment starts with putting together a portfolio of high-quality stocks. Although high-flying growth stocks may be alluring, the risk of a terrible year of returns far outweighs the possible benefits of a fleeting moment of outperformance. Instead focus on ” wonderful businesses ” with high moats that are profitable and that will survive whatever an uncertain economy may throw at them. In addition, focus on dividends and their re-investment. Dividends have historically accounted for the vast majority of all stock returns for the last century. Some have even postulated that dividend growth is the most important factor for creating long-term wealth. Thus, companies with strong returns, consistent earnings and consistently growing payout ratios should see better than expected returns over the long term. 4) Consider Increasing Exposure to Non-U.S. stocks Despite reports of a “relatively stagnant” global economy, research suggests that there are many global markets that are projected to grow at high rates. Although foreign stock outperformance is no sure thing , there are certainly pockets of relative geographic market undervaluation worth considering. In Europe , the UK, Germany and Spain present compelling opportunities. Elsewhere, Singapore, Thailand, Australia and Russia remain significantly undervalued by Prof. Shiller’s CAPE measure. 5) Avoid Chasing Returns And Stay Focused On The Long-Term Common during bull markets yet even more common when markets are going sideways is the impulse to buy stocks that are skyrocketing while your portfolio remains grounded. Yet if you chase the best-performing stocks or sectors you risk leaving your plan behind and jumping in when these assets are reaching their peak. Try and relax, pay attention to valuation and stick to your long-term dividend growth plan. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Scalper1 News
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