Morningstar Advisor - April/May 2010 - 34

Spotlight

A Decade of Riskier Assets ...
By Michele Gambera

Investing has become more difficult since 2008. Many clients believe that the financial crisis has done permanent damage to basic investing concepts such as diversification and buy-and-hold investing, and they think that we need to start from scratch to devise new investment strategies. In my personal research, I have found that although 2008 was unique for its severity and the number of countries that simultaneously suffered recessions, asset classes behaved as they have in the past—a flight to quality made all risky assets drop and bid up the prices of government bonds. And we’re not out of the woods. All asset classes likely will be riskier in the next five to 10 years. Therefore, we may need to tone down our clients’ overall risk exposure a notch. Traditional asset allocations (such as the popular 60% stocks and 40% bonds) may be too aggressive. Generally, I have three main concerns about investing over the next decade: equity valuation, bond volatility, and the failure of investors to learn the lessons taught by this recession. Let’s go into the gory details. First, valuation. Today, equities appear to be either fairly valued or overvalued in most industrialized countries. After a bad decade, one would hope for mean reversion and a few gangbuster years in stock returns. But where are the P/E ratios right now? I wish I knew. Every indicator goes in a different direction. If we exclude negative earnings, P/Es suggest that stock prices are between fairly valued and cheap. If we include negative earnings, P/Es give a very bleak picture. But are negative earnings affected by extraordinary

items? If so, P/Es that exclude negative earnings may be more informative. If not, negative earnings tell the more informative story. Other measures, such as price/cash flow and the Shiller price/moving-average earnings ratio, suggest that the market is fairly priced. (Morningstar’s equity analysts agree: On Feb. 26, the market had a valuation ratio of 1.0, meaning that the market was exactly fairly valued, according to Morningstar’s fair value estimates.) As a whole, it is difficult to say, and in late February, the S&P 500 seemed close to breaking the 200-day moving average from above. My second concern is that bonds will likely be more volatile. Monetary policies have kept rates low for government bonds in the United States and around the industrialized world. Expect rates to increase once economies start picking up steam. At the same time, credit spreads have been decreasing for a year and only inched up a little in January. Spreads seem likely to keep decreasing. Consider that even the Dubai fiasco had little effect on the pricing of credit risk (although a stock market shock or an aggravation of the credit situations in the eurozone might trigger another panic and an increase in credit spreads). My concern is that the forces of increasing government yields and decreasing credit spreads will increase bond volatility. To give an example, I used Morningstar EnCorr to download the time series of monthly yields for the two-year U.S. Treasury bond. I then subtracted (geometrically) the respective trailing 12-month CPI inflation from each monthly observation from June 1976 through December 2009. I found that the median value

for the real yield was 2.12%. The duration on the two-year Treasury is around 1.96, and convexity is negligible for the purposes of this example. Therefore, if the bond yield went from the current 0.77% to its average real level (assuming 2% inflation), one can estimate the price change as: –1.96 3 (2.12 1 2.00 2 0.77) 5 –6.56% In other words, if the bond yield was to jump to its expected average, an investor would have a capital loss exceeding 6%. This is not about bond vigilantes increasing rates because of high government borrowing. It is just a reversion to the mean for a two-year bond, which—it is worth repeating— is assumed to have low interest-rate sensitivity given the short maturity. Last, many investors haven’t learned from their mistakes. Are investors saving enough? Are they paying too much in fees? And how many times are they going to fall for the “this time it’s different” myth? It wasn’t different during the technology bubble, nor was it different during the housing (and commodity and securitized debt) bubble. Why should the next bubble be any different? My advice for the next decade: Start from a well-diversified asset allocation and stick to it through the bubbles and bursts. K
Michele Gambera, Ph.D., CFA, is chief economist of Ibbotson Associates.

34 Morningstar Advisor April/May 2010

Morningstar Advisor - April/May 2010

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