Uncertainty Can Create Confidence

July 31, 2017

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Corey Hoffstein, co-founder and chief investment strategist of Boston-based Newfound Research.

By its third anniversary, it had already been dubbed “the most hated bull market ever.” For those keeping score at home, that was over five years and 100 percentage points ago in the S&P 500.

Being consistently wrong has not stopped market soothsayers from reading the tea leaves and predicting doom and gloom all the way up. While we are sure that a prediction of “the market will go down” will eventually prove true—especially when repeated ad nauseam—to quote Howard Marks, “When you’re early by six or more years, it’s not clear you can ever be described as having been right.”

To hedge our chiding, we’ll note that it is possible that doom and gloom was the higher probability event all along, and that perhaps, somehow, the market has merely managed to deftly leap from one impossible feat to the next.

Fool’s Errand

Or, perhaps, prediction in such a complex and chaotic environment has been, and always will be, a fool’s errand.

Yet as the market continues to make all-time highs, the predictions come rolling in. In many ways, we always seem to be fighting the last recession. With the traumatic dot-com bubble and the housing-driven financial crisis still well within our collective memory, equity valuations and housing prices remain sore subjects.

This makes them perfect data points for stirring up our emotions—those that make us more susceptible to buying whatever convenient panacea is being offered to protect us.

Yet if we take a step back, we may find that many of the facts being frequently touted today lead to conclusions that are not as black and white as they are made out to be.

US Equity Valuations

The dot-com bubble reminded us that while unbridled optimism can lead to astounding technological innovations, it rarely makes for a sound investment thesis. As it turns out, valuations do matter.

Today the Shiller CAPE—a smoothed measure of the market’s price-to-earnings ratio—has edged toward 30: a level only surpassed in the Roaring ’20s and the dot-com bubble. And we all know how that turned out. 

 

Data source: Shiller Data Library. Calculations by Newfound Research. Shiller CAPE is the Shiller cyclically adjusted price-to-earnings ratio, which uses smoothed earnings over the last ten years. Data from 1900 to June 2017.

 

That is the popular narrative, at least. We will quickly point out that a data set of two does not make for a robust sample from which to draw conclusions.

If we look at rolling one-year returns based on the starting Shiller CAPE ratio, we find cause for much less concern. Yes, valuations matter, but the market remains stubbornly random in the short run.

 

 

It is only if we expand our horizon and compare the Shiller CAPE starting level versus long-term annualized returns—e.g., the next decade—that we find some semblence of a meaningful relationship. 

 

Data source: Shiller Data Library. Calculations by Newfound Research. Shiller CAPE is the Shiller cyclically adjusted price-to-earnings ratio, which uses smoothed earnings over the last 10 years. Data from 1900 to June 2017.

 

We will quickly point out again, however, that while drawing a straight line through something can create a rather official-looking relationship, the actual number of data points exceeding a starting Shiller CAPE level of 30 is limited. It is even more limited in meaning when we consider that these are overlapping periods.

Our take: It is reasonable to assume valuations matter. The data does not suggest, however, that high valuations imply any sort of violent and sudden market reversal. Evidence is mostly limited to longer-term forecasts, and even then, data regarding high valuation periods is limited, and we should be reluctant to draw too strong a conclusion.

 

The VIX

Lately, the ultimate “fear indicator” has been indicating anything but. Hitting a near all-time low of 9.36, some argue that market participants have become complacent. The only logical conclusion to that statement is, of course, that we should be more vigilant now than ever.

 

VIX Performance, 1990-2017

Data source: Bloomberg. Calculations by Newfound Research. The VIX (CBOE’s Volatility Index) is a measure of the implied volatility of S&P 500 Index options. Past performance does not guarantee future results.

 

The data tells a different story. The relationship between the VIX starting level and forward one-year equity returns is tenuous at best.

In fact, if anything, history shows that exceedingly low VIX levels have actually been a bullish indicator for short-term returns. We can see below that starting VIX levels between 10-15 have largely led to positive one-year returns.

 

One-Year Forward Equity Return Vs. VIX

Data source: Bloomberg. Calculations by Newfound Research. The VIX (CBOE’s Volatility Index) is a measure of the implied volatility of S&P 500 Index options. Past performance does not guarantee future results.

 

What appears to be a more conclusive relationship is that the VIX mean-reverts. When the VIX is high, it typically falls, and when the VIX is low, it typically rises.

 

1-Year Forward VIX Change Vs. VIX

Data source: Bloomberg. Calculations by Newfound Research. The VIX (CBOE’s Volatility Index) is a measure of the implied volatility of S&P 500 Index options. Past performance does not guarantee future results.

 

Remember: The VIX is not volatility. It is the market’s collective implied forecast of volatility over the next month. All this data is saying is that “when the market predicts low (high) volatility, in the future, it tends to predict higher (lower) volatility.”

Our take: The only thing that a low VIX is likely an indicator of is that the VIX will likely be higher next year. It is worth keeping in mind also that the VIX is merely a forecast of volatility, however, and not a guarantee that volatility will necessarily rise. Even if realized volatility does increase, however, it could very well be upside volatility.

Housing Bubble: Round 2

Few would argue that the housing bubble of the mid-2000s did not have devastating consequences for the U.S. economy. After the bubble burst, the average price of an existing single-family home plummeted nearly 25% in the aftermath and remained depressed for several years. Today those prices have finally surpassed the 2005 highs.

 

Single-Family Home Price

Data source: Bloomberg. Calculations by Newfound Research.

 

Sign of a second bubble? Not so fast. Let’s look at the same data, but using inflation-adjusted prices.

 

Single-Family Home Price, Inflation-Adjusted 

Data source: Bloomberg. Calculations by Newfound Research.

 

What we see is that on an inflation-adjusted basis, the average price of an existing single-family home is still nearly 15% below its all-time highs.

Price and value are different, however. The actual affordability of a house may be a better gauge. For that, we can turn to the Housing Affordability Index. The index tries to measure whether or not a family with a median income can afford a home of median price. Higher values indicate that housing is more affordable.

 

Data source: Bloomberg. Calculations by Newfound Research.

 

The housing affordability index considers three main factors: income, housing prices and mortgage rates. Some may be quick to assume that affordability is largely due to low mortgage rates and therefore could be in doubt should interest rates rise. However, even when we adjust for mortgage rates,* housing prices look fair relative to income levels.

 

Housing Affordability, Adjusted For Mortgage Rates

Data source: Bloomberg. Calculations by Newfound Research.

 

While we’ll be among the first to acknowledge that cheap credit can lead to speculative bubbles (just look at how “affordable” housing was in the early 2000s), today’s affordability looks perfectly normal given the credit environment.

Our takes: (1) Nominal prices are misleading, and (2) price is not value.

Our Convenient Panacea: Admitting We Don’t Know

Instead of continuing to torture the data—and ourselves—in effort to find meaning in the noise, we should instead focus on building portfolios that are robust to many potential outcomes rather than being perfect for a single one.

It is an approach where we openly admit, “I don’t know.” This admission of uncertainty allows us to focus on being vaguely right instead of risking being precisely wrong.

Is indexing in a bubble? I don’t know. But even if it is, we can all benefit from the lower fee solutions it has made available.

Are interest rates going to go up? I don’t know. But even if they do, evidence suggests that the current yield matters far more than rate changes for future bond returns, greatly simplifying financial planning.

Are stocks overvalued? I don’t know. But even if they are, timing markets with valuation measures is notoriously difficult. We should probably only let valuations guide our long-term expectations and only pay attention close in the extremes. To paraphrase Cliff Asness, we should only get excited when things reach their 150th percentile.

Is the market going to crash? I don’t know. But in the last decade, many diversifying asset classes and strategies have come downstream into low-cost and liquid packaging, providing investors with more means to actively manage risk than ever before.

 

At Newfound, we put these concepts into action in our free-to-subscribe QuBe model portfolios, a comprehensive suite of asset allocation models offered across a range of client risk profiles.

We blend a simulation-based optimization approach with forward-looking capital market assumptions. We want to be informed by valuations, but not wholly reliant on them; we want to assume our outlook could be wrong.

Pairing Passive With Active

We couple passive diversification with more active risk management approaches, leveraging strategies like tactical asset allocation, managed futures and long/short equity.

We embrace a hybrid active/passive, multimanager approach. The portfolios balance low-cost exposures from firms like iShares and Vanguard with active solutions from firms like J.P. Morgan, PIMCO and AQR.

Simply: our QuBe models embrace the “I don’t know” philosophy. While hubris of bold claims may be better for sales, we’d argue the humility of admitting we don’t know is better for survival.

 

*We use a simple linear model to predict affordability based upon prevailing mortgage rates and calculate the difference between the forecast and the measured Housing Affordability Index.

 

The company is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. The company offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed-income and liquid alternative asset classes. For more information about Newfound Research, call us at 617-531-9773, visit us at www.thinknewfound.com or email us at [email protected]. For a list of relevant disclosures, click here.

 

Find your next ETF

Reset All