I noticed something interesting this month while updating the IvyVest asset allocation model: the weight the model allocates to US stocks has started to increase again. This month, it hit it's highest level in a while.
This is surprising because for many months, the weight had been slowly declining for reasons that are very easy to understand. The two primary factors the model considers are valuation and momentum. And since 2012, stocks have slowly been getting more expensive (see below as judged by their cyclically-adjusted price-to-earnings ratio), while their positive momentum has remained, but stabilized (below, see previous six month return). Higher valuations combined with lower (while still positive) momentum are a recipe for a declining weight.
Neither of these metrics got meaningfully more attractive in the last month. So what could be going on? In short, what is going on is that things other than US stocks now look like less attractive places to put money than they did a few months ago.
The most important of these "other things" is US Treasury Bonds. Treasury bonds are important because they are the closest thing that exists to a risk-free return, so investors use them as a benchmark in evaluating what price to pay for all other investments.
The standard way to evaluate a Treasury Bond is to look at its yield to maturity, which is just a definition of the return that an investor who owns the bond to maturity will achieve (with some minor assumptions attached). In a completely rational world, investors would judge the value of an investment by discounting its cash flows back to the present value using a time value of money that is computed from the treasury yield (plus a "risk premium" needed for accepting the higher risk). So the ten year yield falling from 3% to 1.8%, as it has over the past year, rationally increases the "intrinsic value" of all other investments, simply because future cash flows are discounted at a lower rate.
The IvyVest model is concerned with after-inflation ('real') returns, so the yield that it most closely tracks is actually not the nominal treasury yield, but instead the ten-year TIPS yield. This is equivalent to the "real" (after-inflation) risk-free return an investor can achieve. It is plotted below.
The ten-year real yield today is essentially zero. So if you want to increase your purchasing power over the next ten years, you are pretty much forced to buy something risky, like stocks.
One simple way to look at the valuation of stocks relative to bonds is to compare the two in like-to-like "yield" terms. But how do we know what "yield" we are getting on an equity investment?
When you buy a stock, you are becoming a partial owner of the business, which means that what you are essentially buying is the future earnings stream of the business (in any given year, most of these earnings may be re-invested in the business, but only if there is the expectation that these reinvestments will lead to future growth). So one way to measure the price of stocks is to calculate how many dollars of earnings you can buy for a $1 investment. This is simply one over the price-to-earnings ratio (or equivalently, the earnings-to-price ratio).
Because we believe in taking long-term averages (to adjust for cyclical effects), we calculate this ratio using the previously mentioned "Shiller PE" or cyclically-adjusted price-to-earnings ratio, a measure that uses inflation-adjusted average earnings over the past ten years, instead of just over one year. Here's how it has trended in recent years (this chart should look like a mirror image of the one above).
A one dollar investment buys you a lot less "cyclically adjusted earnings" today than it has at various times in the past.
This ratio can now be compared on a "like-to-like" basis with the TIPs yield. For instance if the shiller p/e was 20 and the TIPs yield 1%, the cyclically-adjusted earnings yield would be 5%, and the difference between these ratios is 4%. Over long periods of time, the difference in these ratios will has averaged about 3.5%. This is a first-order approximation of the "equity risk premium" -- the additional annual return that equity investors demand to invest in stocks vs. bonds. When this ratio is higher, equity-investors are (on average) receiving an above-average premium for taking risk; when it is low, they are receiving a below-average premium for taking risk. Here's how the story has unfolded over the past twenty years:
That dotted line at 3.5% is the historical average.
Note the opposite pictures given by the two plots above. In absolute terms, stocks look expensive about any way you cut them. But when compared to Treasury bonds, they are now slightly cheaper than average. Not because they have gotten any more attractive, but because Treasury bonds have gotten even less so. More on this next week.
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