Time to Row

Time to Row
July 29, 2011
We have discussed at length the merits of our “Estimating Future Returns” model and its history of providing more accurate forecasts of future returns to stocks than traditional methods.
It is essential to consider the myriad potential outcomes and the likelihood of each outcome occurring when determining whether your current investment strategy is appropriate, or whether an alternative strategy is warranted.
Considering the expected returns for the foreseeable future allows the wealth management process to be more adaptive to market conditions, a characteristic that can add tremendous value to a portfolio and a wealth plan over time. One of the single greatest failings of the traditional wealth management approach is its inability to integrate these ever changing projected future returns into the portfolio management process.
In fact investors almost never receive the very long-term rate of return that the dominant investment theory would predict (Dalbar, 2011). Instead, investors have historically received a random mix of very low and very high returns year in and year out. Worse, these high return and low return periods often cluster together over many years at a time. This is problematic if you happen to retire during a period of sustained below average returns.
These types of multi-decade bull and bear markets exist and are driven by market regimes where economic and psychological forces compel prices to move broadly higher or lower over many years at a time. If you refer to Figure 1 below you will see that retiring in a regime of persistent low returns is just as likely as retiring in a period where markets experience sustained above average returns.
The question becomes: What type of market are you retiring in? Further, what can you do to maximize your chance of a successful retirement?
Our “Estimating Future Returns” model allows us to better inform investors about where they sit today and what their likely prospects are for the medium term. As Ed Easterling of Crestmont Research puts it, valuation models allow us to more accurately gauge whether investors will need to ‘row’ for the foreseeable future or whether they can ‘sail.’
Over the last 100 years there have been four extended periods during which investors were forced to ‘row’ and three periods where investors could ‘sail.’ There was the raging bull market of the roaring twenties, which seemingly defied Washington’s policy makers. The brutal bear market of the Great Depression followed the ‘Roaring Twenties’, and lasted until the end of World War II.
The end of the Second World War preempted the post-war economic boom and concurrent long-term bull market that raged from the late 1940s to the late 1960s. The almost decade and a half long stagnation that followed was sparked off in earnest by the 1973 OPEC oil crisis and the subsequent dramatic rise in inflation expectations which pushed interest rates to their century highs by 1981.
This period was followed by the longest sustained bull market in the history of the United States, from the early 1980s to the ‘Tech Bubble’ in 2000. We have subsequently experienced the current decade’s financial turmoil which has seen financial markets recover from the depths of the Tech Bubble only to be met with substantial difficulties stemming from the collapse of the U.S. housing market in 2008; a state from which the market still has yet to fully recover.
Figure 1
   Source: Butler|Philbrick & Associates (2011)
What this should illustrate is that markets come in all shapes and sizes, and that the traditional ‘Buy & Hold’ approach to investing may not be the optimal strategy in all market environments.  Additionally, sustained bear markets inevitably follow sustained bull markets. Unfortunately, no one knows precisely when the switch will flip from one market regime to the other.
This creates the need for a strategy that is not only effective during both rowing and sailing environments, but which can also be effective during the transition between these two market regimes.
Rowing requires a dynamic and adaptive approach with periodic readjustments, while ‘sailing’ only necessitates letting the prevailing wind propel you toward your financial goals, while making minor adjustments once in a while to stay on course. Passive strategies like ‘Buy & Hold’ work adequately, but only in ‘sailing’ markets. In ‘rowing’ markets the only positive returns that investors receive are necessarily taken from someone else, as it is a zero sum game.
If you look at Table 1 below, you will notice that our “Estimating Future Returns” model very accurately estimated the forward fifteen-year market environment for both bullish and bearish market regimes of the past century. While traditional Advisors would have you believe that the best estimate of portfolio returns is always the very long-term average of 6.5% after inflation, our model has historically delivered much higher levels of accuracy. You can see in Table 1. that in sailing environments this 6.5% estimate is usually too low, while in rowing environments it is much too high.
Table 1
Source: Shiller (2011), Doug Short (2011), Butler|Philbrick & Associates (2011)
If the model’s past success is any indication, then we observe a high likelihood that investors will face a rowing environment over the next fifteen years. During these types of market regimes, it is essential to have a strategy that is adaptable to many different market environments, and can scour the globe for the best opportunities. In our next installment, we discuss a strategy that has the potential to deliver substantial risk-adjusted returns in all market environments, and demonstrate how it managed to deliver positive returns, even during one of this decade’s most challenging years.