Market Outlook 2014

(This was going to be a longer piece but I’d touch on the highlights below.)

Let’s jump right in – how did broad asset classes perform in 2013? Short answer – a monster year for US stocks, bad for bonds and commodities.  Foreign equity markets and real estate were mixed.  Below is a representative table of 20 basic ETFs across the broad asset classes:

FIGURE 1 – Asset Class Returns 


Foreign Developed Stocks:


Foreign Emerging Stocks:



Now, on to what to expect in 2014…


 1.        2013 – A Monster Year for Stocks…

US equity markets had a banner year in 2013 with the S&P 500 up 32%.  While this number sounds large, as Fisher is fond of saying, “normal market returns are extreme”.  Below is a chart with the distribution of all US stock returns since 1900.  As you can see, most years are positive, but there are certainly some massive outliers on the good and bad side.  Fat tails are the norm.


Figure 2 – US Stock Market Returns Since 1900



 Source: GFD


Even though we have had quite a run since the 2009 bottom, up 179% for US stocks, the past thirteen years have been difficult for most investors

US stocks have returned a meager 3.58% per year from 2000 – 2013, and factoring in inflation, have returned 1.2% per year.  That is, if the investors had the ability to sit through two gut wrenching bear markets with declines of over 45%, and according to recent DALBAR studies, many have not.  The average equity investor underperformed the S&P 500 by about 4% over the past 20 years.  (Bond investors are equally as bad.)


2.        …But Valuation Will be a Headwind

One of the reasons for the subpar returns is simple – valuations started the 2000s at extreme levels.  The ten year cyclically adjusted price to earnings ratio (CAPE) reached a level of 45 in December 1999, the highest ever recorded in the US. We are nowhere near bubble territory, nevertheless, stocks are on the expensive side.


FIGURE 3 – 10 Year Shiller PE (CAPE) Values


Source: Shiller 


As you can see in the figure below, future returns are highly dependent on starting valuations.  The current reading as of the end of 2013 is 25.4,  above the long term average of around 16.5.  At the current levels of 25+, future returns have been uninspiring. 


FIGURE 4 – CAPE and Future Real Returns


 Source: Shiller 

While many have critiqued the legitimacy of CAPE, realize all of the valuation metrics are in agreement – US stocks are expensive – they just disagree on the magnitude.  (Even Siegel’s NIPA measure argues stocks are expensive historically.)  While we don’t think we are anywhere near a bubble, returns should be muted going forward.  Perhaps 4% nominal is a good target.  If margins revert, 0% is a real possibility.  


3.        Small Cap Stocks and Dividends are Expensive

Small cap stocks had an even stronger year than the broad market in 2013, up 37%.  However, this performance has led small caps to be at a high relative valuation to large caps, and a high absolute valuation relative to their own history.  Investors should consider a cap agnostic approach or perhaps eliminate small caps altogether.  

 FIGURE 5 – Small Caps Relative to Large Caps


Source: Leuthold


 FIGURE 6 – Overall Small Cap Valuations


Source: Leuthold

Another area of concern within equities is the high dividend yield space.  Historically dividend stocks have traded at a discount to the overall market, but as money has rushed into dividend stocks, the high yielding dividend stocks are trading at a large premium to the overall market.  

We feel the same about many low volatility strategies that are no longer trading at low volatility levels…consumer discretionary should also underperform as it finds itself at one of the higher multiples in history on both an absolute and relative basis.  


FIGURE 7 – Dividend vs. Shareholder Yield Valuations


 Source: OSAM


 4.        Bonds will not help a 60/40 get to 8%


US government bonds proved to be a wonderful place to hide out during the past 13 years.  The compound return was 5.9% and a nice 3.4% after inflation.  The problem with these returns, however, is that they come at the expense of future returns as yields have declined.  2013 proved to be a tough year for bonds, with yields on the 10 year rising to around 3%  and the same bonds suffering a 8.6% decline. 

Future bond returns are easy to forecast, they are simply the starting yield.  Your ten year return for buying US government bonds will be around 3% currently.

So, investors are presented with the following opportunity set (assuming 2% inflation going forward, and rounding to make it simple):

US stocks:  4% nominal, 2% real

US Bonds: 3% nominal 1% real

That leaves a 60/40 investor with a 3.6% nominal return, or a 1.6% real return.  Not exactly exciting, and nowhere near 8%!

So where should investors look for outsized returns while managing their risk?


5.   Where to Look?  Go Global

The European crisis has pushed down many foreign and emerging country stock valuations to low levels.  Some countries, like the PIIGS (Portugal, Italy, Ireland, Greece, and Spain), are trading at low CAPE levels below 11 (Greece and Ireland are both below 8).  The broad MSCI EAFE is around 16, and the MSCI EEM is around 15.  The US is the most expensive developed or emerging country at a value of 25!  Nine countries are below a CAPE of 10 and twenty are below a value of 15.  It makes a lot of sense, especially for those that are heavily overweight US stocks, to consider a more global approach with an allocation to foreign stocks.  The United States only accounts for about 20% of world GDP, and half of market cap, but most US investors have a much higher allocation of around 80% to US stocks (which is what is typical around the world with this home country bias).  Most stocks around the world are cheap:

FIGURE 8 – Average Valuations Around the World




We also firmly believe, as central banks continue their fight against inflation, in the strategic allocation to real assets, including real estate through domestic and foreign REITs, and various commodity exposures.  A simple allocation of these assets, as detailed in our book The Ivy Portfolio, would have done decent job at navigating the past 13 years of market volatility.  While there was a lost decade in US stocks, a balanced global asset allocation performed much better. 



As demonstrated by the returns over the past 13 years, choosing a strong approach to managing assets can make a big difference to a portfolio.  Avoiding common mistakes, such as emotional decision making, only focusing on traditional asset classes , and not having a risk management plan, is important.  Often investors don’t have the time or the patience to manage their assets effectively. Consider reducing exposure to US stocks (small caps and high dividend yielding stocks) in favor of foreign equities.  Within equities, consider a value approach.  Within and across asset classes, consider using trendfollowing methods to reduce risk and exposure to catastrophic loss.



9% Alpha with Munger and Van Gogh

I’ve done this post every year since Ivy Portfolio came out (you can see last years longer post here).  I’ll let you read the old ones if you want, but needless to say it was another banner year for 13F tracking.  The average fund that we published in our book beat the S&P by 12 percentage points.  (HT AlphaClone, top 10 holdings equal weighted.)

So, for the 13F detractors out there, this is now 5 years of out of sample performance.  4/5 years the portfolio beat the S&P.  Total outperformance?  9% per year.  That’ is monster outperformance!

2013 stats – zero negative funds (no surprise with the S&P up 30%+) though ESL and Pershing Square were the two worst.  Some monster years out of Cannell, Second Curve, King Street, and Brave Warrior.

And if you still don’t believe me, there are a few 13F ETF trackers out there doing a fine job as well…



Crowdsourced Research

I am holding a cover design contest for my next book, and you can vote here if you want to take a peak. As usual the one I like the most is running in last place!  But then again I profess no taste or marketing eye.

I then saw a tweet where an individual build a google docs sheet to track one of my old models:


This got me thinking – I wonder if there is more to be done with outsourcing research?  I know Quantopian does a lot of work with algorithms and eventually I’ll come up with an idea to post to Kaggle.  Here is a starter project, and the first one to build this correctly will get a free sub to The Idea Farm (I’ll give up to three if anyone builds them).

Recreate Siegels NIPA CAPE Excel sheet.  Resources here:



Shiller Excel

To make everyone’s life a little easier, I shortened the domain a few letters.  It will redirect but you may also want to update your links…

Everyone Hates Emerging

I’ve done a ton of posts on home country bias (people allocating more to stocks in their own country).  Most US investors place 80% in the US, when the US is only ~50% of global market cap and about 20% of global GDP.  Interesting to note, that of their public equity exposure, Harvard and Yale only allocate 1/3 to the US.

Valuations abroad are much more reasonable than in the US (CAPEs in EAFE and EEM around 15/16 vs 25 in the US, and small caps are at 30).

More interesting to me, all the strategists hate emerging! via @ritholtz




CAPE Returns for 2013

Did CAPE work in 2013?  Below are end of 2012 updates, new CAPE values mailed to Idea Farm today…Also below is a chart of average and median CAPE values across 55 markets over time…






ETF Returns for 2013

Here is a large graphic of various ETFs for 2013. 



What Will Move Margins Next?

“Our best guess?  Gravity”  - Leuthold Group

Here is my monthly roundup of good reads and notes from my Twitter feed @MebFaber



Valuation Distributions Across Time

This is a good post over from the Eudora Fund website looking at the distribution of value factors across time…

Quotes from site:

For readability’s sake, I’ve bolded the 5th and 95th percentile values, as well as the median, in each of the valuation distributions. Some interesting statistics from the above chart:

  • The most expensive part of the market, i.e., the 95th percentile, is more expensive today than it was at the top of the 2007 market, trading at more than 13-times enterprise value to revenue vs. about 11-times in 2007.
  • The cheapest part of the market today, i.e., the 5th percentile, is actually slightly cheaper than it was in 2007 at 0.37-times EV/Revenues vs. 0.44-times EV/Revenues. Strangely, the cheapest part of the market in 2000, was even cheaper than today.
  • The median stock is valued at roughly the same today as it was in 2007, at around 1.9-times EV/Revenues. This is about 10% cheaper than the median stock’s valuation in July of 2000.
  • Parenthetically, the most expensive EV/Revenue portion of the market in 2000 was simply insane, at close to 50-times revenues.


Ev-to-R-Distributions (2)


Lots of people commenting on a recent article from the very good blog Philosophical Economics written by @Jesse_Livermore.  I’m writing a book on the topic of global stock valuation models probably out in January (and having a design contest for the cover here now).  

An investor needs to be aware of the benefits, as well as the drawbacks of using any investment model.  Too many people follow their models and opinions with religious like zeal, much to the detriment of their portfolios.  Below we examine a few of the criticisms commonly heard when discussing the CAPE ratio.

 Measurement period is too long.  Critics claim recessions and expansions have an outsized impact long after they have faded from memory.   “Estimating Future Stock Market Returns” by Adam Butler and Mike Philbrick tackles the issue of different measurement periods from one year up to thirty (as well as other valuation models).   We take up this topic in an old blog post here and show the ideal period centers around seven years (thanks Ben Graham!).  But realize that 1 year PE ratio works pretty well too.  Note that CAPD works too!

It is impossible to compare across decades due to changes in accounting.   One of the things that makes me really queasy as a portfolio manager is when people make “adjustments” to historical price data.  The classic example is excluding 1987 from the analysis as an outlier.  Why would you exclude something that actually happened?  However, much like in our Shareholder Yield book, it is important to understand when there is a structural change in a market, and when is this time really different?

Critics complain about write downs and how that biases CAPE. However, critics also claim adjustments to CPI and accounting rules render comparisons across decades, or even centuries meaningless at worst, and at best inaccurate.  

I’m not an accountant, but we will examine some ways to think about the above criticisms and see if they impact the measure, and if so, by how much.  I really like Liz Ann Sonders at Schwab – she has a good piece on all things PE and makes a few comments:

 “More recently, the move toward fair-value accounting standards resulted in security losses having a devastating effect on the reported earnings of financial institutions during the recent financial crisis. Yet that effect now appears to have been transitory. If an accounting item is deemed non-recurring, it’s common practice to ignore it when determining underlying earnings (i.e., using “operating” instead of reported earnings). But CAPE continues to reflect the effect of non-recurring items for the 10 years that follow their initial recognition in reported earnings.”

The blog Philosophical Economics examines how reported earnings in the US have been inconsistent over time.  Shiller uses Generally Accepted Accounting Principles (GAAP) earnings from S&P, also known as reported earnings.  However, the early 2000s witnessed the introductions of FAS 142/144 which altered how companies amortize goodwill.  I will not bore you with a long overview, but this has the potential effect of biasing earnings down, and CAPE up.  Another CAPE critic, Jeremy Siegel, penned this note in the FT back in August 2013 in “Don’t put faith in CAPE crusaders”:

 “I believe the Cape ratio’s overly pessimistic predictions are based on biased earnings data. Changes in the accounting standards in the 1990s forced companies to charge large write-offs when assets they hold fall in price, but when assets rise in price they do not boost earnings unless the asset is sold. This change in earnings patterns is evident when comparing the cyclical behaviour of Standard and Poor’s earnings series with the after-tax profit series published in the National Income and Product Accounts (NIPA).”

Siegel has a white paper “The Shiller CAPE ratio: A New Look” and powerpoint presentation here.  (I added his charts at the end, but note all measures show some overvalucation currently.)

I used the series from Bloomberg mentioned in the Philosophical Economics article, and you can see the difference in the below Figure, and note the similar tracking until the early 2000s.




 Source:  GFD, Bloomberg, Philosophical Economics

Which series is “correct”?  Well, they both are, but perhaps the red line is more consistent across time.  I honestly don’t know, but a better question is, does it even matter?

Below is a Figure of both CAPEs, adjusted and non-adjusted.  While the CAPE declines from ~25 for the reported earnings series to ~21 for the non-GAAP series, both reach the same conclusion generally and currently, albeit with different magnitude .  US stocks are not cheap.  While we agree there may be some variation, in our paper we examine the CAPE in over 30 foreign markets with supporting results.





 Source:  GFD, Bloomberg, Philosophical Economics

A similar take on the topic is from Societe Generale who put out an excellent piece titled “To Ignore CAPE is to Deny Mean Reversion”.  They use the MSCI earnings index that doesn’t include the writedowns and they come to the same conclusions as using the S&P series – some overvaluation. 

Recessions bias CAPE up.  Bubbles bias CAPE down. People often find a way to justify their market stance.  I’ve humorously received both of these critcisms from market bulls and bears!  Here is a sample from one of my friends “We don’t like using the CAPE because it includes 2008-2009 earnings which distorts the PE since earnings are too low.” My response to this is, well, according to your logic, do you also exclude 1999 and 2007 as being abnormally high?  And then, if you make the adjustments, does it even matter?  This is a similar, but slightly different argument (one off recessions) than the prior one (an accounting inconsistency). 

Below we adjust the earnings series from Shiller to pretend like 2008/2009 never really happened.  We adjusted the earnings series so that earnings didn’t decline in 2008 and 2009 (they had already started to decline a bit in 2007).  The second chart is the adjusted CAPE series.  If you adjust the data it moves the CAPE from approximately 25 to 23.  There is basically no difference and stocks are still expensive, but not terribly so due to the mild inflation sweet spot we are in.



 3Source:  Shiller, GFD.




 Source:  Shiller, GFD.


CAPE isn’t really a short term timing measure for one market.  Like most valuation measures, it is a blunt tool and it’s not that helpful telling you what to do for the next few months.  It makes much more sense to align the indicator with the measurement period. However, pretty much every value measure we track aligns to say the same thing – US stocks are expensive.

As Dr. Hussman shows in his weekly commentary and in his chart below, it doesn’t really matter which market valuation metric you prefer, most signal a bit of overvaluation to the market.  It’s nothing nearly as awful as the late 1990s, but it means that until this valuation “burns off”, which can take years, decades, or possibly even a month or two if we had a crash, we will have somewhat muted returns of perhaps 2-5% nominal per year.  Below are his charts that examine some basic valuation metrics.  (We also examined this in our paper on the FF data with totally different metrics and dataset with similar conclusions, value works!)




Even Mr Bogle uses a different metric – P/B on the Dow (from BI).


CAPE and other valuation methods are interesting on a stand-alone basis – but in this global age why focus on only one country?  Much more important is expanding the opportunity set to include all of the countries in the world and buying the cheapest instead of the owning the most expensive and often biggest by market cap. 


Siegel’s Charts:





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