Tuesday, December 10th, 2013

Concentrate on the Extremes

There are numerous academic studies which show that there is a significant inverse relationship between PE ratios and subsequent returns from US equities. This is a sensible and not very surprising conclusion. Few investors realise that most of the power of this analysis derives from the extreme cases. In the middle of the range (which is where we are now) the PE ratio is not often the critical factor in determining index performance. Nor is a mid-cycle estimate of earnings growth, which is more or less in line with the long-run trend. The resulting index target may a reasonable forecast, but it doesn’t address the main issue, which in our view in 2014 will be volatility – or risk.

Risk is more influential than valuation
Our approach to asset allocation is based on the existence of a powerful and persistent negative relationship between excess risk* and excess return. This is also a common-sense result, which we describe on the website and in our marketing literature, but it is worth noting that the correlation is more significant and more persistent that than the equivalent test using PE ratios. When excess volatility is low we expect excess return to be high and vice versa. The current reading for excess volatility is close to its extreme reading and is therefore more likely to be influential in 2014 than any valuation metric or growth forecast.

Approaching a cyclical low
For US equities vs US bonds, excess volatility is in the 3rd percentile of its range since 1995 (inception for our model). It has only been lower on 3% of occasions. The current reading for excess return has only been higher on 16% of occasions (84th percentile). The obvious explanation for this is QE and the obvious risk is the start of the taper, whenever that may be. Unless something very odd happens, this analysis suggests that when the taper starts (1) the volatility of equities and bonds will both rise (2) the excess volatility of equities will rise which means that (3) the returns of equities will be impacted more severely than the returns from bonds. This is the opposite of the Great Rotation theory, even though we agree that bonds are more overvalued than equities.

Sector implications
Investors who wish to consider the sector implications of this analysis should be aware that three sectors where volatility is in the 1st percentile of its range over the last 18 years: Technology, Energy and Materials. A general increase in the level of equity volatility will probably mean that these sectors experience a greater increase in volatility than the rest of the index. This may go hand in hand with a greater deterioration of returns.

Excess volatility is approaching cyclical lows. This will rise when the taper starts and should mean that equities sell off more than bonds, irrespective of the PE ratio when this happens. The sectors with the lowest volatility relative to history are likely to impacted most. Small caps, which have similar issues, are also likely to be affected.

(*) All data for risk and return are calculated on annualised basis over the last 26 weeks.

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