We still have some way to go before asset prices normalize for the S&P 500 index, which makes up about 90% of US stock market capitalization. The CAPE and all price-to-fundamental ratios like it (e.g. Tobin’s Q, Buffett’s PE, etc.) are still high and they are all higher than their long-run averages by about the same percentage. That consistency reinforces the notion that it’s the market’s price that is the issue and not that there is something fundamentally different this time with respect to earnings, free cash flow or the replacement cost of business assets.

The CAPE is 24.90 after (last week’s) drop in the S&P 500 to 1970.89. Even if we generously assumed that real S&P earnings for the most recently available month (March 2015’s $100.57) was the proper figure to use in the denominator (as opposed to the lower real $79.13 S&P earnings over the last ten years), the S&P 500 index could still fall another 15% before the CAPE reached its long-term average (16.63). Unfortunately, no one knows when it will regress back to that level. It is impossible to predict it.

In addition, few consider that maybe the current CAPE average is too high. Both the numerator and denominator in the CAPE are adjusted for CPI inflation, so it reduces the ratio to long-run fundamental market and business activity. The CAPE averaged 14.78 from January 1881 through December 1994, which is 11% less than today’s CAPE average since 1881, largely because today’s CAPE average includes the greatest bubble in the market’s history (the dot com bubble). That suggests the S&P could fall 25% from 1970.89 even with the generous earnings figure used for the denominator.

PAR does not care about the market as a whole when it invests client funds in its Separate Account Value Investing (SAVI) strategies, so PAR is not investing as if the market were going to drop another 25%. PAR is still looking from the bottom up for SAVI  clients because that is the way to uncover opportunities that have an MOS, but there should be no surprise that there are far fewer opportunities when the CAPE is 24.9, like today, than when the CAPE is 13.3 as it was in March of 2009.

March 2009  was the last time PAR became fully invested. Most of those new positions in which PAR invested in 4Q08 and 1Q09 to become fully invested were gradually liquidated over the subsequent twelve- to eighteen-months and have largely sat in cash  since. PAR’s SAVI strategies are only a small part of PAR’s clients’ portfolios.

PAR Wealth Management also offers traditional wealth management services as a fee-only fiduciary. PAR Wealth Management is a goals-based financial adviser. Once a client’s goals are quantified and prioritized, PAR Wealth Management allocates that client’s capital to investments with qualities that match those specific goals and how a client feels about risk. Capital for short- and intermediate-term goals are generally allocated to safer, more-liquid investments. For a large percentage of a client’s long-term goal allocation, PAR Wealth Management generally chooses external managers who demonstrate an ability to capture factor premia.

Update 8-24-15: I do not want to leave the impression that the only way for the CAPE to normalize is for the S&P 500 to drop precipitously. The other way is for the denominator–earnings–to rise considerably. But, the denominator will not rise without growth in value-creating economic activity in the private sector, and that takes time. Value-creation has been stagnant since 2008 and there is little on the horizon to suggest that the private sector will turn robust. In any case, the numerator (the level of the S&P 500) would have to rise much slower than the denominator. So, either way, whether it is a numerator that falls or a denominator that rises or some combination, it portends low stock market returns over the next decade. As I have written before, invest accordingly.

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http://www.blackrockblog.com/2014/08/07/great-deleveraging-happened-debt-problem/

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I usually have a negative knee-jerk reaction to anyone who says “it’s different this time” and true to form, I disagree with Sufi’s argument that capital can replace labor completely. His is a Luddite argument that has been made since the industrial revolution and never materialized. Capital can only replace labor when (if?) we reach the Singularity and machines can reproduce themselves. (By machines, I mean both mechanical and electronic.) Until then, back-breaking labor will be replaced by machines that, in order to propagate, will need engineers and programmers and maintenance workers and chip makers, and entrepreneurs who can employ machines in purposeful activity, etc.  That reminds me; I also added Ray Kurzweil’s website to the blogroll.

http://blogs.cfainstitute.org/investor/2014/07/23/debt-and-secular-stagnation-amir-sufi-discusses-the-us-recovery-video/

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At this month’s CFA Institute Annual Conference in Seattle, Sharpe said that Smart Beta made him sick because it implied that index investors had to be “dumb beta.” Sharpe believes the so-called dumb beta investors would eventually gravitate to Smart Beta strategies because no one is that dumb for long, and then the advantages of Smart Beta would simply melt away into average beta.

As regular readers know, Fama and French (F&F), and later Lakonishok et al. (LSV)  (See F&F and LSV tab above) demonstrated as early as 1992 that two factors consistently resulted in outperformance in the long run: Value and Small Cap. It is largely these two factors that put the “smart” in “Smart Beta.” F&F and LSV were not the first academics to publish papers on the value and small-cap factors, but they certainly popularized the factors in academia. Before these academics came along, we had research from practitioners Ben Graham from the 1930s through the 1970s; Warren Buffett from the 1950s to today; and Seth Klarman from the 1980s to today; that demonstrated that value strategies consistently outperform the market in the long run.

Since F&F and LSV published their research in the 1990s, there has been an overwhelming amount of academic research that demonstrates that value strategies outperform. Most of that research proves that value outperforms for reasons that are not related to risk, therefore value has consistently delivered alpha in the long run.

Most Smart Beta strategies are nothing more than systematic ways for managers to capture some of the factors that are known to deliver this alpha in the long run. The adoption of this approach in a more systematic and passive way somewhat proves Sharpe’s theory that no one stays that dumb for long. However, value and small-cap strategies outperform over long periods not necessarily because value and small-cap investors are smarter than everyone else, but because behavioral flaws and institutional constraints do not permit EVERYONE to FULLY capture the alpha in value and small cap. I remind you that it did take over 150 years for Smart Beta to be born.

Only small investors with contrarian streaks (see my future post on Investor DNA) can fully exploit these factors. Even Smart Beta strategies will fail to fully exploit these factors because of the amount of capital that Smart Beta will need to invest. Much of that capital will have to be allocated to large cap firms, but most of the alpha in these factors is found in relatively unknown and un-followed small-cap firms.

So, my answer to Sharpe’s queasiness is this: Smart Beta is just a label. Would he have taken less umbrage if that label were “Behavioral Beta” or “Factor-Focused Beta?”

http://advisorperspectives.com/newsletters14/Bill_Sharpe-Smart_beta_makes_me_sick.php

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1. He’s super-smart;

Yet, as Buffett himself has said, if you have more than 130 IQ points you should sell the excess because you won’t need it to be a great investor. In fact, that extra IQ may be detrimental if it leads to behavioral flaws such as overconfidence or lack of discipline.

2. He’s guided by an overarching philosophy;

That philosophy is value investing, which can be executed in several forms.

3. He’s mentally flexible;

It may seem as if Buffett had a change in philosophy when he transitioned from Ben Graham’s “Net Net” and “Cigar Butt” approaches to investing to Charlie Munger’s “wide-moat” approach. However, all three approaches are guided by the value-investing tenet that requires a Margin of Safety.

Graham’s margin of safety was found in businesses trading at less than the net value of their assets. Munger’s approach of investing in under-appreciated companies with wide moats found a margin of safety in well-run business with pricing power and even growth. The key is in the qualifier “under-appreciated.”  Value investors love growth, but tend to be more skeptical of growth projections than glamour investors, and are usually better at maintaining discipline when pricing growth, and rightly so.

Hence, value investors usually buy fast-growing, wide-moat companies only when the market does not fully appreciate their wide moats as much as it should. One example: Buffett paid $1.02 billion for shares of Coca Cola by the end of 1989 after the 1987 crash had damaged Coke’s shares. By 1999, that investment was worth $11.6 billion according to Hagstrom.

4. He’s unemotional;

Marks: “Many of the obstacles to investment success relate to human emotion…perhaps worst of all, (most investors) have a tendency to judge how they’re doing based on how others are doing, and to let envy of others’ success force them to take additional risk… (Warren) doesn’t care whether others think he’s right or whether his investment decisions promptly (my emphasis) make him look right.”

My Take: Warren is disciplined, which can make a person appear unemotional. I would be willing to bet that on more than one occasion in his career he lost sleep over a decision, but that his discipline allowed logic to triumph.

5. He’s contrarian and iconoclastic;

As Charlie Munger likes to say, I have nothing more to add.

6. He’s counter-cyclical;

Marks: “Many of the best investors accept that they can’t predict what the macro future holds in terms of economic developments, interest rates and market fluctuations…the greatest bargains are accessed by buying when the economy and companies are suffering…how many acted as boldly (as Buffett) when fear of financial collapse was rampant (in 2009)?”

7. He has a long-term focus and is unconcerned with volatility;

One should only invest in the equity or long-term debt of businesses to cover long term liabilities such as college tuition that is due in twenty years, retirement liabilities, and bequests, so volatility is the friend of the long-term value investor. Volatility gives the long-term value investor the chance to buy low and eventually sell high, in contrast to what most investors do; that is, buying when rising prices make them feel good and selling when plummeting prices are too painful to bear.

This is where a good wealth advisor comes in for an individual investor or family office. He or she will help such investors identify their goals and estimate when the invoices for those goals need to be paid. Then, a good advisor will allocate assets to broad asset categories that “immunize” those liabilities and help make the euphoria of rising prices and pain of plummeting ones easier to ignore and bear because short-term goals are covered in cash or high-quality short-term debt, and opportunities to cover long-term goals will arise over a multi-decade run.

This is known in High Net-Worth Investor (HNWI) Wealth Management circles as Goals-Based Investing (GBI).  The underlying assumption is that all investors would be happy to simply meet their goals and avoid their nightmares so that they can focus on their careers and the things that make them happy.

In GBI, capital for near-term goals is held mostly in cash and short-term bills, and capital for long-term goals is invested in less liquid or more volatile (in the short run) investments such as equities, long-term debt, real estate, and alternatives in order to exploit the return premiums that are available there.

Within asset categories a good advisor will help clients find investment managers who understand each asset’s risks and who can manage those risks well. He will also find managers who can exploit specific premiums in those asset classes such as the value premium in equity investments.

8. He’s unafraid to bet big on his best ideas;

So many active investors have capital spread thinly, and almost all of it is allocated to S&P 500 companies. They have low “active share,” so they are essentially closet indexers who charge higher fees than indexers.

9. He’s willing to be inactive;

According to a speech that Seth Klarman delivered at a Grant’s conference in the fall of 2013, Baupost Group has about 50% in cash. Klarman is fearful of returning cash to his investors because he believes that they may go out and invest it with a hot-hand manager and will suffer during an inevitable shakeout.

PAR views cash as an investment in an option on every asset, an option that has no expiration date. That option is worth quite a lot right now.

10. Finally, he’s not worried about losing his job;

Professional portfolio managers who work for large firms lose their jobs if they underperform. That is why many make the rational decision to become closet indexers in order to hug their benchmark and avoid underperformance.

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http://amarginofsafety.com/2013/03/01/the-equity-market-annual-return-histogram-updated-for-2012/

Yesterday’s Wall Street Journal Ahead of the Tape column by Spencer Jakab had a chart titled  ”Unhinged,” in which Jakab showed average stock market returns relative to average GDP growth during the last eleven recoveries from a recession. The market return is almost FIVE times GDP growth in the current expansion, but averaged only 1.47 times GDP growth in the previous ten recoveries.

Is 2013 going to be one of the once-every-nineteen-years when the market rises over 40%? Can a market rise that much on Federal Reserve balance sheet growth alone? Perhaps, like in 1928, this party is still in the ten o’clock hour. What will happen when the clock strikes midnight?

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A lot of truth here.

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Good Stuff.

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Guess what I “predict” for 2012? Years highlighted in orange relate to the Great Depression; blue relates to the credit crunch. Notice that there were many more extreme years during the Great Depression than recently.

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